The hardest part about investing in individual stocks is the research. Companies and their financial records can be incredibly complex – Johnson & Johnson, for example, has more than 250 subsidiary companies under its well-known brand name.
So how should an investor start their research? This is an incredibly important question for young adults to figure out as it can make a huge difference in their returns.
Evaluating the Business
I like to start first with the softer side of finance: the business. You have to get a firm grasp of what the company does from day to day.
The perfect starting point is a company’s annual report. You can find an annual report on the company’s investor relations tab on its website. Larger companies also distribute printed annual reports for free through http://www.annualreports.com/
I stress starting with the annual report because it is where companies show off. Sure, there is plenty of financial information to be found in an annual report. But annual reports often show the softer side of the business complete with pictures of the company’s products, short and sweet future business plans, and even awards and recognitions the company received in the past year.
Publicly-traded companies are often involved in more businesses than you might think. Without an interest in finance, you might think General Electric just makes light bulbs and wind turbines. However, after looking through the company’s annual report, it becomes clear that GE is really just a bank that happens to make industrial products “for fun.”
So, in short, you have to actually know what the company does before you do anything else. You might be surprised to learn how complicated seemingly simple businesses really are.
Learn from the Pros
If you are new to individual stock investing, you can learn plenty by listening to what other people want to know about a company. I like to attend a company’s conference calls where analysts ask executives in-depth questions about a business.
If you cannot listen live, conference calls should be recorded and available on the investor relations section of a company’s website. Alternatively, SeekingAlpha has transcripts of conference calls for all large publicly-traded companies that you can read on your own time.
Focus on what the analysts want to know. There is always a good reason behind each question. If an analyst wants to know about a company’s debt level, it should be a sign that you should take a second look at the company’s debt in your analysis, for example.
Getting to the Numbers
Eventually, you have to get the nitty-gritty of breaking through a company’s financials. Here are a few key numbers to focus on:
1. Price-to-earnings ratios – How expensive is the company’s future earnings? A PE ratio is the price of a share of stock divided by its future earnings. A low PE is more favorable to a high PE. Realize that earnings can vary wildly from year to year. An average of the last 5 years earnings would give you a more realistic PE ratio than a single year.
2. Price to book ratio – How expensive is the company relative to its book value? A book value is to a business what “net worth” is to a person. A low book value may be a sign that the company is selling at a big discount, especially if it also sports a low PE ratio.
3. Return on assets – How much can a company generate in earnings for each $1 it uses to run its business? A high return on assets is indicative of a very productive company. A higher return on assets means the company will use less of its earnings on investments (factories, new storefronts, etc.) to grow a business.
4. Total share count – How well is the executive team managing the company for shareholders? In an ideal world, share count would not rise faster than earnings.
5. Earnings growth – How quickly is the company growing its earnings over 5-10 years? Is this growth sustainable? For example, Apple quadrupled its earnings over the course of 3 years from 2008-2011 from sales of iPhones and iPads. Is there really room in this world for Apple to sell 3 times more iPhones and iPads in 2014 than in 2011?
Attack Whole Industries at a Time
A great place to start is with companies and industries that you can understand. Everyone can understand the pizza franchising business. Here are some of the companies in that industry:
Pizza Hut owned by YUM! Brands (YUM)
Papa John’s (PZZA)
Papa Murphy’s (Privately owned)
Noble Roman’s (NROM)
Just off the top of my head, here are some questions that need to be answered before you invest:
• How do these companies make money? What percentage of their earnings comes from company-owned stores vs. franchises?
• Why would a franchisee pick one of the brands above? (How much does the average store earn? How much does it cost to start a pizza franchise from any given brand? Is Papa John’s franchising agreement noticeably different from competitors?)
• Why do customers favor a particular store? My grandpa likes take-n-bake pizza because he can’t eat a whole pizza at one time. Is this common? Will demographics favor one company over another?
• How big could one of the above companies become? (Noble Roman’s is a $14 million business. It could grow 88x over if it replaced Papa John’s. Can it do that? Can Papa John’s, which has thousands of locations, grow much larger? Where?)
• Can any of these companies raise prices in the future? Every pizza chain is running specials due to the recession, but if the economy improves, maybe they could manage to add $1 to the price of each pizza sold. Could this be a catalyst for heftier stock valuations?
• Frozen pizzas have become a big business, and their quality is improving over time. Do these pose a threat to the traditional pizza shop model?
You can read financial reports all day long and never answer any of the questions above. Investors have to go deeper to find information that the market overlooks or underappreciates. As you start looking through new investments, keep a detailed log of research and intriguing information you find about a business or industry – you may want to reference it later.
Knowledge Builds on Itself
The best part about investing is that knowledge and research compounds faster than your money. What you learn about one industry can help you in others. The factors that affect pizza chains aren’t all that much different from the burger business (Wendy’s and McDonald’s.) Wendy’s (WEN) and McDonald’s (MCD) aren’t all that different from “fast casual” restaurants like Chipotle (CMG) or Panera Bread (PNRA).
Health insurance companies will lead you to an understanding of health care delivery. Health care delivery will help you discover which medical products would make winning investments. The list goes on and on.
The most important point is that finance is not all about numbers. Investing does not require a tremendous amount of mathematical prowess. What it does require is a firm understanding of a business. Getting involved in business analysis early allows you to build a knowledge bank of information that you will carry with you your whole life – information you can use to find many more good investments in the future.