Step 3: Research each company/stock on your list
Understand the company's business.
When you buy a stock, you're really buying part ownership in a company, and you should only invest in what you understand, so the more you learn about the company's operations and business model, the better your evaluation will be. Are they in an industry that's growing or shrinking? Is it an industry you understand? Do they sell products and services you think will become more or less important in the future? Visiting a company's website is a quick way to see how they present themselves to the world. For a more detailed picture, check out their latest annual report. You may even want to compare it to their earlier annual reports, to see how they've been progressing and to see whether they underpromise and overdeliver or vice versa.
Check the financials.
Here are some numbers that can help you evaluate how the company is doing (other important numbers are in the next three sections):
Book value: Since companies are usually expected to grow and generate more profits in the future, most companies end up being worth far more in the marketplace than their book value would indicate. For this reason, book value is of more interest to value investors than growth investors.
Dividends: The dividend yield measures what percentage return a company pays out to its shareholders in the form of dividends. Mature, well-established companies tend to have higher dividend yields, while young, growth-oriented companies tend to have lower ones, and most small growing companies don't have a dividend yield at all because they don't pay out dividends. For companies that pay dividends, consistent and growing dividends are best.
Beta: This is a measure of how much the stock tends to move up and down in price relative to the overall market. A high number means more volatility, so high-beta stocks tend to be less appropriate for risk-averse investors.
Debt/equity ratio: This is a measure of a company's financial leverage, and is equal to long-term debt divided by common shareholders' equity. Investing in a company with a high debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt.
Examine the income statement.
Along with the balance sheet and the statement of cash flows, the income statement is one of the three key financial sections in a quarterly or annual report. Here are some important numbers to check:
Revenues: This is the total amount of money received by the company for goods sold or services provided during a certain time period.
Earnings: Also called income, this is a measure of how profitable the company was. This number is divided into the price to calculate the P/E ratio.
GAAP Earnings: GAAP stands for Generally Accepted Accounting Principles. It's a widely accepted set of rules, conventions, standards, and procedures for reporting financial information, as established by the Financial Accounting Standards Board. When the GAAP earnings number differs substantially from the standard earnings number, it's worth investigating.
Gross margin: This tells you how much a company earns taking into consideration the costs that it incurs for producing its products and/or services. Gross margin is a good indication of how profitable a company is at the most fundamental level.
Net margin: This is similar to gross margins, except it takes into account all of the expenses associated with the business, including marketing expenses, administrative expenses, etc. (so it is equal to net income divided by net sales). Net margins provide an overall picture for the company; this is what shareholders and investors usually watch most carefully. Low (or negative) net margins might indicate that the company is struggling or is in a competitive industry in which it doesn't have very much power to dictate its prices.
Return on equity (ROE): This is calculated by taking a company's after-tax income (after preferred stock dividends but before common stock dividends) and dividing by its book value (which is equal to its assets minus its liabilities). It is used as a general indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. Investors usually prefer companies with ROEs that are high and increasing.
Examine the balance sheet.
The basic concept underlying a balance sheet is simple enough: total assets equals total liabilities plus equity. You can use the balance sheet to determine the firm's liquidity, to see how leveraged the company is, or just to see all the specific assets and liabilities of the company. Some important numbers:
Current Assets: These are defined as assets that can or will be converted into cash quickly (generally within one year). Current assets include cash and cash equivalents (money market accounts, etc.), the company's inventories (unsold stock), and its accounts receivable (uncollected bills from its debtors).
Current Liabilities: These are the amounts the company expects to pay out within the next year. Current liabilities include accounts payable (bills the company must pay), interest on long term debt, taxes, and dividends.
Current Ratio: : This is an indication of a company's ability to meet short-term debt obligations; the higher the ratio, the more liquid the company is. Current ratio is equal to current assets divided by current liabilities. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liablities exceed current assets, then the company may have problems meeting its short-term obligations.
Examine the cash flow.
The third financial statement to examine is the statement of cash flows. Most of the information found on the cash flow statement is contained in either the income statement or the balance sheet, but here it is organized in such a way that it is difficult for companies to use accounting tricks to obscure the facts. Some numbers to watch for:
Cash flow from operating, investing, and financing activities: These sections show how much money the company took in as a result of each of these three activities. Obviously, in general a positive cash flow is better than a negative cash flow, and any large discrepancies are worth investigating.
Free cash flow: While free cash flow doesn't receive as much publicity as earnings do, it is considered by some experts to be a better indicator of a company's bottom line. Free cash flow is the amount of cash that a company has left over after it has paid all of its expenses, including investments. Whereas earnings reports are potentially subject to a number of different accounting tricks which can artificially boost the bottom line, free cash flow is not. It is quite possible, for example, for a company to have positive earnings and negative free cash flow. Negative free cash flow is not necessarily an indication of a bad company, however; many young companies tend to put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, you should probably be investigating why it is doing so and what sort of returns it is earning on its investments.
Check long-term stock and company performance.
Comparing revenues and earnings year over year and quarter over quarter is a good way to see if the company is moving in the right direction. It can also tell you if their business is steady or cyclical. Many investors prefer companies that grow revenues and earnings consistently and predictably.
Check recent stock and company performance.
Legendary investor Benjamin Graham said that in the short run the market is a voting machine but in the long run it's a weighing machine. Many investors look for a history of long-term success but try to get in on a dip, which means they're looking for a stock chart that goes up gradually over the long term but has recently dropped. (It's worth pointing out that momentum investors often do the reverse, looking for stocks that have been very strong recently in the hope that they'll continue to go up.) In addition to checking the stock chart, also see if there's been any company-specific news or press releases recently, and pay attention to general economic and business news to the extent that you think it might affect the company's price and value.
Consider the outlook going forward.
Does the company have strategic advantages over current competitors? Does it have a "moat" to keep out new competition? What do analysts say about projected earnings for next year and beyond? Are the predictions all about the same, or is there a wide variance? If you can identify companies that you think will be successful in the future, especially if others think those companies won't be successful, those companies could represent good investment opportunities.