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Evaluating companies for investment purposes

When it comes to buying stock, many investors get lost in the stock price. That is, the buyer is more concerned with the current up and down movements in the stock than the company fundamentals.

An investor should look at the company for the next three to five years, not the next three to five days. But what are some of the fundamentals that the investor can look at to start the research?

First, look at the PE, or price-to-earnings, ratio. This tells you how much you are paying for the earnings of the company; the lower the ratio, the better. Price to sales is another ratio that lets you know what you're paying for the sales of that company. A look at the price to book reveals how much you are paying for the equity of the company. And lastly, the price to cash flow shows how much is being paid just for the cash flow that the company is bringing in. All these ratios should be compared to the industry average in which the company competes. And with all these ratios, the lower the number, the better.

It is also important to look at two items in regards to the growth of a company: sales growth year over year, and earnings growth year over year. These are percentages, and the higher the number, the better. Unlike the ratios, which you want to be lower than the industry average, here it is better to be higher than the industry.

Many investors want to be conservative but never look at the balance sheet to see how strong the company is financially. A current ratio tells how much the company has in short-term assets to pay off short-term debts. With a current ratio, a higher number is better.

Another concern when buying stocks is how much debt the company has. A very good indicator is total debt to equity. Here you are seeing how much debt the company is holding and comparing it to the total equity of the company. Generally, the lower the number, the better, but a comparison to the industry average can be helpful, since some companies, like utilities, cannot operate without debt.

To find out how effective management is, an investor should look at the return on equity, sometimes referred to as ROE. The higher the ROE, the better.

It is also important to look at the company's bottom line to see if it is profitable, known as the net profit margin. The higher the net profit margin, the more the company is making off its sales after all expenses have been paid.

You can easily look at the company's efficiency by looking at the receivable turnover and the inventory turnover -- the higher the number, the better. A high turnover on the receivables means customers are paying their bills quickly and the company can use the cash for other needs. A high turnover of inventory means the company's products are moving out of the warehouse and will not spoil or become obsolete, possibly causing a reduction in the price of that product.

Keep in mind that this is just the start of your research, and if all the numbers "check out," you should look closely at the income statement, the balance sheet and the cash flow statement. I recommend reviewing the company's annual report. Also, have a good understanding of what the company really does. Much of this information can be obtained online.

Investing in stocks can be risky, and your principal will fluctuate. It may be best to consult with an investment professional before investing.


Wilsey is a registered principal with Linsco/Private Ledger, a member of the SIPC. "Smart Investing with Brent Wilsey" can be heard Saturdays at 8 a.m. on KFMB AM 760 and Tuesdays at 12:30 p.m. on Channel 8 news. Contact him at brent.wilsey@sddt.com.

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