7 QUESTIONS TO ASK BEFORE BUYING STOCK

Value and growth investors seldom agree on what's important when evaluating a stock. Here are seven questions every investor, regardless of persuasion, should ask before plunking down money:

What does the company do?
Do you know what your company actually does for a living? Is it in a hot growth sector, a saturated industry whose best growth days are long gone?
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How many widgets are they selling?
Companies make their bucks by selling stuff, and lots of it. Most publicly traded corporations rack up sales running into the hundreds of millions of dollars annually.
When you buy companies without significant sales, you are buying the "story," not the company's fundamentals. Some will succeed, but it's risky business. Risk averse investors will avoid lots of heartaches by sticking with companies racking up at least $1 billion in annual sales. At the very least, go no lower than $10 million in sales in the most recent quarter.

Just how profitable is the company?
For stocks, profitability means more than not losing money. I'll explain with an example. Consider two hypothetical companies, Company A and Company B, both selling widgets for $100 each. But let's assume that, after considering all expenses, Company A makes $50 on each widget sold, but Company B makes only $25 per widget. If they both sell a million widgets a year, Company A's profits total $50 million compared to Company B's $25 million.

Why is profitability important?
Each year, Company A has $25 million more extra cash than Company B. It can use that cash to develop new widgets, build more factories, pay dividends, etc. Since it doesn't have that $25 million, how can Company B keep up with Company A's spending? Only by raising more cash, either by borrowing or selling more shares. Both alternatives diminish shareholders' earnings. Obviously, you'd be better off owning Company A than Company B, but how do you know which is which? That's where profitability measures come into play.

Return on equity (ROE), the ratio of a company's 12 month net income to its shareholder equity (book value), is the most widely used profitability gauge. But relying on ROE has a downside. It sounds counterintuitive, but if you do the math, you'll find that all else equal, high debt companies have higher ROEs than low debt companies. So you'll end up overweighting your portfolio with highdebt stocks if you go by ROE alone. You can get around that conundrum by using return on assets (ROA) instead. ROA is net income divided by total assets, which includes liabilities. Consequently, everything else equal, the lower the debt, the higher the ROA. Avoid ROAs below 5%.

Is cash flowing in or out?
Cash flow measures the amount of money that moved into, or out of, a company's bank accounts during the reporting period. Cash flow is a better profit measure than earnings because it's harder to finagle bank balances than numbers like depreciation schedules that figure into earnings. In fact, many companies that report positive earnings are actually losing money when you count the cash.

There are different cash flow definitions, but operating cash flow, which measures the cash flow attributable to the company's main business, is a good place to start. Find it on the quarterly cashflow statement by selecting Statements under Financial Results, at the left of the quote page, and then selecting Cash Flow and Quarterly from the dropdown menus.

It's a little tricky to read because the quarterly columns reflect the year to date (cumulative) totals, not the quarterly results. For starters, you want companies with cash flowing in, not out. So look for positive figures in the latest quarter's Net Cash from Operating Activities row. Any positive number is OK, but it's best if the operating cash flow exceeds the net income (top line) for the same period.

Is the company submerged in debt?
High debt is not always a bad thing. But many experts predict that interest rates will increase with a recovering economy. If that happens, the rising rates will result in higher debt service costs, cutting into the earnings of debt heavy companies.

The financial leverage ratio (total assets divided by shareholders' equity) is a good allpurpose debt gauge. A company with no debt would have a financial leverage ratio of one, and the higher the ratio, the more debt. As a rule of thumb, avoid companies with leverage ratios above 5, which is the average of S&P 500 Index ($INX) stocks. Leverage ratios lower than 5 are better. You can't apply the leverage ratio, or any other debt measure, for that matter, to banks and other financial organizations. These firms always carry high debt compared to firms in other industries.

Any bad news lately?
Negative news, such as an earnings shortfall, problems with a new product, an accounting restatement and the like not only pressure the share price, but often portend even more such news in coming weeks. Negative news is the death knell for growth stocks, and growth investors should avoid all such stocks like the plague. Even value types, who seek out stocks beaten down by bad news, should wait on the sidelines until reasonably sure that there is no more to come. Think months, not weeks.

Which way are forecasts moving?
Despite the hullabaloo about analysts and their credibility, there is still much to be gained by tracking their earnings forecasts. Zacks Investment Research and other compiling services tabulate and then average analysts' forecasts into a consensus earnings forecast for each stock. The consensus numbers tend to move in trends. Why? I'm not sure. One reason may be that after one analyst makes a significant change, others reexamine their models and then revise their estimates in the same direction. Avoid stocks where the latest fiscal year estimates are more than two cents below the 90 days ago figures.

Answering these seven questions will help you make better investing decisions, but they are just a start. Dig deeply and learn all you can. The more you know about your stocks, the better the choices you will make.