Evaluating Companies

Introduction to Stocks

A company's earnings and what it has paid in dividends can be a useful indicator of what's in store for a particular stock.

Most investors realize that it's important for a company to have a good management team. The problem is that evaluating management is difficult - so many aspects of the job are intangible. It's clear that investors can't always be sure of a company by only poring over financial statements.

Fallouts such as Enron, Worldcom and Imclone have demonstrated the importance of emphasizing the qualitative aspects of a company. There is no magic formula for evaluating management, but there are factors to which you should pay attention.

Stock Price Isn't Always a Reflection of Good Management
Some say that qualitative factors are pointless because the true value of management will be reflected in the bottom line and the stock price. There is some truth to this over the long run, but strong performance in the short run doesn't guarantee good management.

The market behaves strangely in the short term. Strong stock performance alone doesn't mean you can assume the management is of high quality.

Length of Tenure - One good indicator is how long the CEO and top management has been serving the company. A great example is General Electric whose former CEO, Jack Welch, was with the company for around 20 years before he retired. Many herald him as being one of the best managers of all time.

Quality - There are a number of ways that you can zero in on a company's quality. Is it debt-free or up to its ears in interest payments? Does the firm have a lot of cash? Is it generating a lot of cash and spending that money efficiently? Are sales and earnings growing at an admirable clip? Are gross, operating, and net profit margins growing, as well? Is the management smart and executing well? Is the company well-positioned to beat out competitors? Does the company have a brand name that is widely known and admired?

Price - When evaluating a company's price, you shouldn't be interested in how many dollars one share costs -- you need to measure the per-share cost of a stock against something. Investors typically take a number of measures and compare them to the firm's earnings. The price-to-earnings (P/E) ratio, for example, compares a company's stock price to its earnings per share. Some companies aren't properly valued based on their earnings, though (because there may not be any), and often the price-to-sales ratio is used. Another earnings-based ratio is the PEG, which compares the P/E ratio to the company's earnings growth rate.

Strategy and Goals - Ask yourself, what kind of goals has the management set out for the company? Does the company have a mission statement? How concise is the mission statement? A good mission statement creates goals for management, employees, stockholders and even partners.

Insider Buying and Stock Buybacks - If insiders are buying shares in their own companies, it's usually because they know something that normal investors do not. Insiders buying stock regularly show investors that managers are willing to put their money where their mouths are. The key here is to pay attention to how long the management holds shares. Flipping shares to make a quick buck is one thing; investing for the long term is another. A great example is Bill Gates: although he sells to diversify, a large portion of his wealth is held in Microsoft stock.

The same can be said for share buybacks. If you ask management of a company about buybacks, it will likely tell you that a buyback is the logical use of a company's resources. After all, the goal of a firm's management is to maximize return for shareholders. A buyback increases shareholder value if the company is truly undervalued.

Here are some steps you can take to broaden your range of understanding:

* Try out the company's product(s) or service(s). Be familiar with how it is improving and what
   the demand for it is.
* Read up on the company. Find books and articles on it.
* Figure out what the company's business model is. How is it making money? How is it
  organized? How might the model change in the years ahead? On what assumptions is the
  model based?
* Examine the company's competitive environment. What are its competitors up to? Is the
  company likely to fend off attacks? What advantages does the company have over the
  competition? Is it at any disadvantage? How is the industry changing and what challenges does
  it face?
* Think about the company's risks. In SEC filings, particularly 10-K reports, the company's
  management will have explained some risks that they see.
* Crunch a bunch of numbers. See just how quickly sales are growing. See what the firm's
  debt-to-equity ratio is. Determine what its gross margins are.
* Talk to people in the business, such as company employees, suppliers, people in stores that
  sell the company's products, customers of the company, people familiar with competitor
  companies, and so on. See how they perceive the industry and where it's headed. See what
  they think of the company you're studying and its future prospects.

The decision to purchase a stock can't be made solely by evaluating companies. You should evaluate company's stock as well for a review of financial ratios.