Time to Make Cents

Intelligent investors spend a lot of time analyzing businesses that they want to invest in. Both quantitative and qualitative factors are important to look at. For example, if an executive leaves an organization and there is an aura of concern and uncertainty of her replacement, then it can negatively affect that company’s stock. Sale numbers aren’t everything! Information about competitors, the industry, society, the economy and politics all need to be understood and interpreted in terms of how they can potentially affect a stock’s price. It is easy to forget that so many factors affect a stock’s price and to only use one element to base an investment decision off of. This is a recipe for disaster! Keep abreast on current news by reading the newspaper and always ask yourself “how will this affect (company that you are either thinking of buying or already own) in the future”. You will be surprised at how much seemingly unrelated events can impact your personal finance decisions!

Do not forget, information is only as good as it’s source. Everywhere you look, someone has some hot tip. So called “experts” on TV seem to suggest twenty different stocks that you MUST invest in everyday. Evaluate the source of the information before acting upon it. if you do like what you are reading/hearing do your own homework to verify what you have learned. Many people (especially on the internet) share positive information about companies that they own to raise their stock’s value. Disclosure regarding an author’s/speaker’s involvement with the companies that they are talking about should be shared at all times. If you are reading information about a company that seems to good to be true, it most certainly is (especially on the internet)!

As should be apparent by now, an investor needs to know a lot about a company (and other external factors) before purchasing shares in the organization. Because of this, it is often suggested that investors look at the companies and industries they know about and have relationships with. If you are a technophile then you have a much greater appreciation and understanding of how a new development can affect the industry. You would already have a general sense of which businesses were stronger in the industry and which to look out for. This head start will increase your self-confidence (in terms of investing) and should make finding worthwhile businesses to invest in easier. Overtime, as you complete more research, you will learn more about other industries and will be able to effectively invest in them as well.

A common mistake that novice investors make is assuming that because a business provides a quality good or service, it is a good stock to own. This is a poor investment strategy because quality goods and services do not guarantee a quality business. Many of the indicators that determine whether a business is worth owning can be found on the businesses balance sheet and income statement. The balance sheet communicates a businesses financial period at a point in time. Every quarter, public companies will release a balance sheet with their quarterly reports. It will list the assets the organization own, the liabilities it has incurred and the amount of equity that the firm has. The quarterely report will also include a current Income Statement. The income statement communicates the amount of money earned or lost by a business in a given time period. Information is categorized by money that enters the business (revenue) and money that leaves the business (expenses). In all cases, when evaluating financial statements, a business figures should be compared to past statements and competitors in the industry. On their own, financial statements are relatively useless. What does it truly mean if a business has six billion dollars in cash on hand? It is only when we compare a businesses figures with other businesses that we can actually gain any information. Both www.investopedia.com and www.fool.com provide tutorials on how to use these statements to create meaningful information.

In general, there are some important indicators that should be understood when choosing a stock. Firstly, it is important to understand exactly what net profit is. As explained earlier, revenue is all the money that a business takes in The amount of money it costs to directly produce the goods or services sold (the cost of goods sold) must be accounted for (because it is not profit). The amount a business earns after taking account of the cost of goods sold is called gross margin, or gross profit. There are still many other expenses that a business needs to incur that indirectly help in the production of the good or service (such as administrative costs and wages). After these costs are accounted for, the money left over is the net profit or a net loss. If a business earns more money then it spends, it will have a net profit. If expenses are greater then revenue, the business will incur a net loss.

A ratio that is often used to discuss businesses prosperity is Earnings per Share (EPS). This is calculated by dividing the net profit a business earns (minus the dividends paid on preferred shares) by the number of shares outstanding. A negative EPS can exist when a business incurs a net loss. The EPS signifies the amount of profit earned by a business, per share. It is important because it is useful for another ratio, the Price to Earnings ratio (P/E ratio). The P/E ratio dictates the amount owners are willing to pay per dollar earned and is calculated by dividing the current market value of a stock by its EPS. The higher a P/E ratio is, the higher the expectations of owners. Once again, it would be wrong to say that a certain P/E ratio is good because it truly depends on the industry. The P/E ratio helps to explain why a $10 stock can be a rip-off and a $100 dollar stock can be a good deal. It all depends on the amount you must pay for each dollar earned. The P/E ratio should be utilized with a host of other ratios and information. A high P/E ratio (in relation to competitors/the industry average) does not necessarily mean that a stock should not be purchased. Once again, every situation is unique and should be analyzed accordingly.

After analyzing a business you may determine that it is the greatest potential investment of all time. Unfortunately, you only have $1000 to invest. If you could, you would invest much more. Trading on margin is essentially investing with borrowed money. In certain situations (like the one I outlined) trading on margin might seem like an excellent opportunity. This all goes back to what I was saying in an earlier entry. There is no such thing as a guaranteed stock. Anything can happen in the stock market, at any time. No matter how great a stock may seem, using borrowed money to pay for it can lead to much more trouble then it is worth. Not only can you now potentially lose everything you invested, you will then owe the money you borrowed (and lost) plus interest. Heavy investing on margin lead to the Great Depression experienced after the stock market crash in 1929. Learn from those who made mistakes in the past…. NEVER INVEST ON MARGIN!

When you find a business that has great potential for the future, make sure to research it’s price history. A stock may have a low P/E ratio in relation to the industry, but perhaps it has historically always had a lower P/E. Remember, every aspect of a stock must be researched before a decision is made. A stock near it’s 52 week low is not necessarily a bargain if there is nothing but bad news and a negative outlook of it’s future. The price is one piece to the entire puzzle and should be researched accordingly.

Once you have a stock in your possession, relax! Consistently watching its movement throughout the day will drive you bananas. Remember, you have bought your stock based (in part) on historical performance that has been collected for years. Why would you then make a hasty decision regarding the stock’s purchase within a few hours? A stock needs to be given the time to do what you purchased it to do. Your personal finance goals cannot be achieved overnight, so do not expect your stocks to perform any differently! This does not mean that you should forget about the stocks you own, leaving them to the market’s devices. Check your portfolio on a weekly basis. Anything more and you will likely make poor decisions based on unsubstantial trends. Anything less and you potentially might miss the opportunity to get out of a stock before it is too late. Pay attention to news about the stock. If your outlook on the stock changes you may want to evaluate your position on the stock and sell your shares. One “never fail” system to ensure that you do not sell your shares at a lower price then you want to is to initiate a stop loss order. A stop loss order tells your broker to sell your shares once a stock reaches a certain price. For example, once a stock hits a certain price target, you may set a stop loss order to ensure you will realize some profit on the stock and will not lose it all as a result of a steep fall in price. Stop loss orders are particularly useful in situations where you will be unable to adequately keep on top of your portfolio (such as when you are on vacation). A stop loss order can ensure you are still working towards your goals; even when you are unable to actively follow your portfolio.

Overall, investing can be very rewarding. Financially the benefits are obvious. Mentally, the exhilaration of choosing a great stock is equally as satisfying as the monetary benefits. My last word of warning is to always invest with your head and not your heart. Regardless of how you may feel towards a company at the end of the day, this is your money. Invest intelligently!