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Investment guides
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| Investors' Tips: High School Economics Teacher |
General suggestions
When my students are considering an investment in a company, I encourage them to start research in three places: the statement of earnings, statement of financial position, and statement of cash flows.
The statement of earnings will give them an overall picture of the company's revenue, its costs, and the resulting profit.
The statement of financial position will give them a cumulative performance of the company over time, showing assets versus liabilities and net worth.
The statement of cash flows will tell how much money came in and how much went out. It may give insight into how the company is being managed, ultimately answering the question: Is management making wise use of resources?
However, these numbers by themselves should not be used to make decisions about investing in a company. I do not put a great deal of significance on numbers alone because they can be manipulated, and oversight and enforcement may not be 100% effective at all times. You must look inside the company for answers.
If a company shows a profit on the statement of earnings, I tell my students to find out why — even if it means calling and asking a company official or reviewing the company's Web site. Asking the right questions can identify the reasons for a profit. Has the company introduced a new product that boosted sales? Has the company's management changed tactics, such as increasing efficiency or entering new markets? Has the competition changed, causing the company to gain new customers? If a profit resulted because the answers to these questions are yes, it can indicate a healthy, growing company.
On the other hand, a profit on paper can sometimes result from practices that are not good for the company's long term health. For example, although cost-cutting is often desirable, it can have serious consequences. If cost-cutting brings about a greater efficiency without sacrificing quality, the company may be a sensible investment. However, if a company cuts costs by reducing product quality, it will probably lose sales in the future. If you are investing your hard-earned money, you want to feel confident a "financial wizard" has not been manipulating numbers that will mislead you.
I also tell my students that a loss on the statement of earnings does not always indicate a weak company. A company showing a loss might be investing heavily in research and development to perfect future products, which could result in greater future profits. A company could be experiencing temporary losses due to bad decisions. A stockholder must ask: Are these decisions irreversible or just temporary setbacks?
If a loss has caused a company's stock price to fall, stockholders must ask: Is this stock "on sale" (a bargain investment that will increase in value) or "down the drain" (a losing investment that will continue to decline)? The answers to these questions will not be found in the standard financial statements. These statements are simply starting points for further research.
A company is in business to make money. If the company shows a negative cash flow on the statement of cash flows, it is spending more than it makes. As a potential investor, you must ask: How long can the company survive following its current practices? Is this a "temporary" negative cash flow that's part of a bigger overall plan for a more profitable future? Or is the situation one which the company can not turn around?
This statement can help give a clearer picture of what is going on inside a company. The statement should contain information on how the profits are being dispersed. If a large percentage of the profit is being declared in dividends, it could indicate the company is not planning for expansion and innovations. Such practice could result in a decrease in the value of the stock in the future. Accepting a financial page at face value could be a big mistake.
Make sure you always do your homework to understand that information in the bigger picture.
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