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Evaluating Companies

When you're considering a company to invest in, you might want to explore the company's products or services, its management, sales and earnings, and outstanding debt. You should also consider its performance during the ups and downs of the last full economic cycle. Taken together, this information may help you make an informed decision about its growth potential and how much it's worth. We'll cover a few key things here, but this isn't an exhaustive list of every piece of information you should consider before investing.

Profits Matter

Net earnings are a company's profit after it has paid all of its other bills, like operating expenses and taxes. A profitable company may be able to use these earnings to expand without borrowing more money or issuing more shares, which would reduce the value of its existing shares.

Sometimes, companies use profits to grow their operations by purchasing other companies. They may also buy back shares of stock that investors own to reduce the float, or number of shares available for purchase. Buying back shares can increase demand and boost the stock's price.

Or, if it wants to, a company can use part of its profits to pay dividends to its shareholders.

It's All in the Numbers

When you look at a company's statistics, be sure to look at earnings per share (EPS). That number is the company's earnings divided by the number of outstanding shares. The goal of EPS is to show a number that investors can understand and to make it easier to compare companies of different sizes. Remember that "good" profit margins are different, depending on the industry and sector, and a good comparison should keep that in mind.

Return on assets (ROA), return on equity (ROE), and return on invested capital (ROIC) are three other measures of profitability (though they're not the only ones). Among other things, they help to measure how efficient the company is in using its capital. If a company's ROE is higher than its ROA, it may be a sign that it's borrowing money to increase profits and profit margins. This approach may or may not be sustainable in the long term.

What's the Potential?

One thing to look for in a company's potential growth is a pattern of increasing sales and earnings, usually shown as an annual percentage. Regular growth, especially when it's from new products or marketing strategies, could be a healthy sign. It's probably a better sign than a one-time jump in earnings from increased prices instead of increased sales.

Growth potential can be different depending on company size. A successful small company in an expanding industry may have more potential to grow faster than a large company in an established industry.

What's the Value?

You can use ratios, sometimes called multiples, to evaluate a company's stock price compared to its finances. The best-known multiple is the price-to-earnings ratio (P/E). You find it by dividing the stock's current price by EPS, and it tells you how much investors are currently willing to pay for each dollar of a company's earnings.

For example, a company whose P/E is 28 has a much higher multiple than a company whose P/E is 10. A high P/E may mean that investors are willing to pay more because they believe the company is a promising investment and that the price will continue to climb. Or, it may also mean that the stock is selling for more than future earnings may justify. That's called overvaluation.

On the other hand, it's possible that the company with the lower P/E is undervalued because it's not popular even though it has strong potential for future growth. Or, it could mean that the company has serious problems that investors think could limit its future success.

Say Ahhh!

Debt can be a major factor when you analyze financial standing. A company with a lot of debt might find that its liabilities limit its earnings potential. Too much debt could even drive the company into bankruptcy.

The debt-to-equity ratio divides total debt by the value of the outstanding shares and is another ratio used to assess financial strength. The higher the percentage, the higher the company's debt level. For companies having financial difficulty, another important measure is the current ratio. This ratio compares liquid assets (cash) to the liabilities (debt bills) due within the year.

How much debt is too much? It's hard to say, because it depends on the business the company is in, its ability to repay, and how the debt is being used.

Assessing Risk

No company evaluation would be complete without a careful analysis of the risks it faces. Among other things, assessing risk means asking:

  • Does the company's business strategy have the potential to succeed?
  • What situations or events could undermine the strategy?

When making this judgment, one approach professional stock analysts take is to imagine a variety of situations that might occur in the near- and longer-term and decide which are the most likely.