Investing 102

Now that you've 'passed' investing 101, you're ready for investing 102. Let's start getting our hands dirty by digging into the important parts of a company. Before you ever think about how to buy, sell, or trade a stock, you need to know how to actually evaluate the company. This means you've got to know how to red their financials.

Financials - Income Statement, Cash Flow, Balance Sheet

The first thing I look at when I open up a company to start painting a picture of their worth is their income statement. This is where you will find the company's profits, expenses, and of course their overall revenue. The big thing to remember with an income sheet is that it shows these things only over a period of time such as the past year (or if you want, a specific year that you're interested in). Think of it as a report card for the entire semester of school rather than someone coming in and looking in at the worst possible time. Sometimes those two can go hand in hand but it's important to remember that the income statement is for the total over the year (this way you don't get confused later when we review balance sheets).

The income statement is very important because each company is required by law (Securities Exchange Act of 1934) to file their total income for the year. This is because originally, the stock market was nothing short of a bunch of people loaning money to others and hoping that it would pay off - it was a business loan. Someone wanted to start their business or expand their business and they needed more money to do so. They then "went public" by selling a part of their business (stocks) in return for more money on the dollar than that company actually produced. An income sheet is required of that company to show the investors how that company is actually doing so that the investor can keep an eye on their investment.

Moving on however, let's open up a balance sheet. This can most typically be found by searching up the company that you're interested in and opening up their 10-K report - more often referred to as an annual shareholders report. Once opened, find the first thing listed which should be the income statement. Inside you will find all sorts of terms - net revenue, net operating revenue, cost of goods sold, gross profit, etc. The first thing that should be looked at is their EBIT or otherwise referred to as operating profit. This is how much the company made after subtracting all the expenses other than of course taxes and interest. Ignore this as it is horribly incomplete. Instead look for either EBITDA or EBT. EBT stands for earnings before taxes and EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It's quite the mouth full, right? Make sure that these numbers are positive. If they are, move on. You're on the right track. If a company isn't positive with either than EBITDA or EBT, leave them be. If you aren't profitable before taxes and interest, you're going to have a hard time being profitable beyond it without some magic. This is because once you've got your EBITDA or EBT, you've still got to subtract any taxes and or interest payments. Move on to the next lines which should be net profit or net income after tax. These are the numbers to be concerned with because they show how much is really left over after most everyone is paid. If the company you're looking at is in the green (is profitable) than you can move onto the next step.

From what is left over, the company now a choice to make. They have to decide how they will spend the profits that are left from their operations. Before that however, you can stop and see a short cut to not having to do all the work that was done above. When a company shows a profit, the company then has another number that is calculated; it can calculate the EPS - the earnings per share. If for instance, your company had $10,000 in profits (hopefully they have more...) than they need to determine how much each one of their shares that they issued to stock holders is worth in regards to their profit. If you have 500 stock holders, you would simply take the $10,000 in profit and divide it by the number of shares.

10,000/500 = 20

This means that the earnings per share (EPS) of the company in question would be 20. This means that each share of the company is attached to $20 of profit. Not bad at all! Obviously you want this number to be as high as humanly possible. The higher the EPS, the more profitable the company you're looking at and you can therefore use the EPS as a quick guide to seeing if a company you're looking at is profitable. One headache down, 1,000 more to go!

Returning to our profits, let's assume that the company we're looking at decides that part of their profits will be paid out to their investors (dividend payment). If you're interested in knowing whether or not a company pays dividends, look at their stock page and see if they have a yield listed. The yield is the percent dividend payment they make in relation to the price. In this case, it's best to look at the amount paid which can be found right next to the yield (usually expressed in dollars if you're on the US stock exchange). This means that they will pay out 'x' amount of dollars per stock to the investors in the company, usually quarterly or annually but sometimes monthly.

Now to calculate the dividend payout ratio. You can find this by taking the annual dividends and dividing it by the EPS. If you're company has an EPS of 5 ($5) and you paid out $1 in common dividends annually per share, that means your company has a payout ratio of 20%. It's important to keep this ratio in mind as this is probably the most important thing for any dividend investor to know. This is because the lower the payout ratio, the higher chance you have that the company you're looking at will continue to issue dividends. This is only different for MLPs and REITs but we will get to that at a later time. Remember it like this - if a company has a low payout ratio, that means they have tons of extra cash even after they've paid off their investors in order to reinvest in the company or continue on as a profitable enterprise. If the ratio is too high, they could find themselves will too little cash later to continue paying dividends or raising them in the future.

Let's move on to P/E ratios. This is the price-to-earnings ratio. This compares the price of the stock on the market to the earnings per share. I personally like to aim for stocks that are in what I call the sweet spot. This 'sweet spot' is between 10 and 20. Any lower than 10 and the stock looks too close to a value trap. A value trap is a situation that occurs when a stock is so cheap in relation to the earnings it generates that there is clearly something more to the picture and you'd best be checking into it before thinking you're somehow the only one who saw how good a price the stock was at. Two high on the other hand and the company would appear to be over valued by many investors. This is not uncommon to occur with technology stocks as they are generally considered growth stocks and are therefore valued higher because of their future chances of huge capital gains.

Let's move on to cash flow. Where the income statement provides us with a view as to what is coming into the business, the cash flow statements show us what is really being bought with cash or how much is being generated. Don't worry about figuring out how to calculate any of this as each company that trades on the exchanges is required to file a 10-K which shows their statement of cash flow. Pull up one if you have one available.  Even though this may look strangely like the income statement, the key difference is that cash flow statements show depreciation and amortization. This is very important when you talk about business that have factory components that wear down over time such as auto factories. They require constant maintenance and therefore can take out tons out of the bottom line.

Separate out the cash flow statement to make it more readable. Most investment sites like Yahoo Finance do this for you already if you use them. It should be first broken down into key categories such as flows from operating activities and investing activities. Cash flows from operating activities is cash that was generated by the business product itself. If you're a car manufacturer, this is where you put you cash generated from auto sales. As for investing activities, this is where a company shows how much they generate through investing in equipment, buying and selling on the market, or by purchasing other companies. Finally, there is another section for cash flow from financing. This is where you can see how much a company is making by issuing bonds, stocks, or other financing activities.

Finally, let's look at the last item on the financials; let's look at the balance sheet. This is what I like to call the bread and butter. The reason I refer to it as such is that it shows how much money is really made and how much you actually have in terms of assets and liabilities. It's a lot like when you do your own budget to find out how much you yourself are worth in terms of net worth. You take all the loans you have and subtract them from how much money you really have. If you're in the positive, you're worth something. If you are negative, you've got a negative net worth and therefore you'd have a negative balance sheet.

These are just a few of the most important things to watch for when you first start to evaluate a stock. This tells you what I would argue to be 90% of a stock's value right from the get go. The great thing is that most financial websites or investor relation modules will list all of these for you without you ever needing to do the math for any of it.