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Measures like return on equity and return on assets help you understand how efficiently a company allocates its resources, and they allow you to look beyond raw profit numbers. Companies with same earnings figures might have very different returns on equity and returns on assets, depending on how well they have turned their assets into profits.
4. How Healthy Are Its Finances? Earnings and cash flow are two different things. You could earn a very generous salary but still run into cash-flow problems if you get paid only twice a year. Because of quirks in accounting practices, a company’s reported earnings often differ from amount of cash it brings in door. The statement of cash flows, which is part of annual report, will tell you just how much of money a company pocketed.
It’s also important to see how company uses that cash. Digging into cash flow statement to find out where money’s going can shed light on management’s strategy and give you additional insight into company’s future. Is it building aggressively for future by opening new stores or building new manufacturing facilities? Is it buying other firms, paying off debt, building up cash reserves, buying back stock, or paying dividends?
Companies can also issue debt to finance new plants and research efforts or to bail itself out of short term cash problems. Companies need to watch their debt levels, though. Too much borrowing can force company to use its cash to pay interest, instead of applying it to more productive ends.
No hard-and-fast rule will tell you how much debt is appropriate for a particular company, because levels of indebtedness can vary across industries. To get an idea of whether a company is overburdened by debt, divide its assets by its equity. The result is company’s financial leverage.
5. Is It Worth Price? A company might clear all these hurdles, but sell at too high a price to be an attractive investment. It all depends on how much its prospects are worth.
To figure that out, look at its forward Price/earnings ratio, for example General Electric has a forward P/E of 41, which means that shareholders now pay $41 for $1 of company’s future earnings.
Another widely used measure is price/book ratio. That shows how much shareholders are paying for $1 of company’s assets.
Whichever ratio you use, compare it with its parallels for other companies in its industry and for market as a whole. That will tell you how expensive stock is, relatively speaking. Remember, stocks with very high P/E and P/B ratios can fall dramatically when any little thing goes wrong.
Analyzing stocks isn’t easy, but you will be off to a solid start if you ask these questions first before buying a stock.
Tanner Larsson is a veteran entrepreneur and the publisher of the award winning Work At Home Success Newsletter. Subscribe to his newsletter and recieve 4 EXCLUSIVE Bonuses valued at $276. http://www.work-at-home-resource-center.com