7 questions to ask before you buy a stock

By Harry Domash

Value and growth investors seldom agree on what's important when evaluating a stock. Here are seven questions every investor, regardless of persuasion, should ask before plunking down money:

What does the company do?

Do you know what your company actually does for a living? Is it in a hot growth sector, a saturated industry whose best growth days are long gone? Or maybe it makes those proverbial buggy whips.

That question is not as silly as it sounds. Sometimes we become so focused on analyzing the numbers, we forget about the big picture.

You probably know what the company does if you're looking at the likes of Wal-Mart Stores (WMT, news, msgs) or Microsoft (MSFT, news, msgs). But it's a different story when we start looking at lesser-known names.

Pop Quiz: Which company is in the fastest-growing industry: OmniVision Technologies (OVTI, news, msgs) or Watsco (WSO, news, msgs)?

You can find out in a New York minute by checking MSN Money's Company Report. To read a report for any stock, look up a quote and then simply click on the "Company Report" link on the left side of the quote page. (You can see OnmiVision's report here.)

Though only one paragraph, these handy reports describe each company's products and/or services in pretty good detail, and they're written in understandable English. You won't find the usual technobabble or meaningless product descriptions such as "enterprise solutions."

The reports give you more than enough info to gain a feel for the company's products and/or services. For instance, OmniVision makes semiconductor chips used in imaging applications, while Watsco is a heating and air conditioning equipment distributor.

What do you do with that wisdom? It depends! If you were looking for hot growth stocks you might glom onto OmniVision and drop Watsco like a hot potato.

On the other hand, value seekers, knowing that the market disses unglamorous industries, seek out stocks like Watsco in the hopes of finding an undervalued gem.

How many widgets are they selling?

Companies make their bucks by selling stuff, and lots of it. Most publicly traded corporations rack up sales running into the hundreds of millions of dollars annually.

When you buy companies without significant sales, you are buying the "story," not the company's fundamentals. Some will succeed, but it's risky business.

Based on my own experience, risk-averse investors will avoid lots of heartaches by sticking with companies racking up at least $1 billion in annual sales. Does that limit the field too much? Not really. When I checked, more than 1,400 stocks fit the bill.

If you are more adventurous, you will want to go lower, of course. But the risk meter goes off the chart when you get much below $100 million in 12-month sales. At the very least, go no lower than $10 million in sales in the most-recent quarter.

You can find the last four quarters' figure (last 12 months) on the Company Report page, and you'll spot the quarterly figures on the Highlights report (first click on Financial Results at the left of the quote page).

You can't apply minimum sales criteria to banks and similar institutions because their income comes from interest earned, which often doesn't show up in the sales totals.

Just how profitable is the company?

For stocks, profitability means more than not losing money. I'll explain with an example.

Consider two hypothetical companies, Company A and Company B, both selling widgets for $100 each. But let's assume that, after considering all expenses, Company A makes $50 on each widget sold, but Company B makes only $25 per widget. If they both sell a million widgets a year, Company A's profits total $50 million compared to Company B's $25 million. Why is that important?

Each year, Company A has $25 million more extra cash than Company B. It can use that cash to develop new widgets, build more factories, pay dividends, etc. Since it doesn't have that $25 million, how can Company B keep up with Company A's spending? Only by raising more cash, either by borrowing or selling more shares. Both alternatives diminish shareholders' earnings.

Obviously, you'd be better off owning Company A than Company B, but how do you know which is which? That's where profitability measures come into play.

Return on equity (ROE), the ratio of a company's 12-month net income to its shareholder equity (book value), is the most widely used profitability gauge. But relying on ROE has a downside.

It sounds counterintuitive, but if you do the math, you'll find that all else equal, high debt companies have higher ROEs than low debt companies. So you'll end up overweighting your portfolio with high-debt stocks if you go by ROE alone.

You can get around that conundrum by using return on assets (ROA) instead. ROA is net income divided by total assets, which includes liabilities. Consequently, everything else equal, the lower the debt, the higher the ROA.

From any stock's quote page, you can see both ROA and ROE by clicking on Financial Results, then Key Ratios, then the Investment Returns section of the Key Ratios report. ROA figures run lower than ROEs. Look for firms with ROAs above 10% and higher is better. Avoid ROAs below 5%.

Since their candidates probably recently stumbled and are reporting losses, value investors should focus on the 5-year average profitability figures.

Is cash flowing in or out?

Cash flow measures the amount of money that moved into, or out of, a company's bank accounts during the reporting period.

Cash flow is a better profit measure than earnings because it's harder to finagle bank balances than numbers like depreciation schedules that figure into earnings. In fact, many companies that report positive earnings are actually losing money when you count the cash.

There are different cash-flow definitions, but operating cash flow, which measures the cash flow attributable to the company's main business, is a good place to start. Find it on the quarterly cash-flow statement by selecting Statements under Financial Results, at the left of the quote page, and then selecting Cash Flow and Quarterly from the dropdown menus.

 1 | 2 | next >