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Tools of Analysis

Even stockbrokers and professional money managers don't agree on which stocks are best to buy—so how are you supposed to figure it out?

One way is to take a look at how a company is doing financially at the moment and how they've done in the past. If Apple has been doing well for the past ten years (and still is), that's probably a surer bet than Bad Investment Company, which—in addition to its unfortunate name—has filed for bankruptcy twice in two years and is up to its rafters in debt.

When a company becomes a public corporation and then starts to trade its stocks on the New York Stock Exchange, it has to file a lot of papers and reveal a lot of information about itself. The New York Stock Exchange also puts the company through a bunch of exams (almost as stressful as your mid-terms) to make sure that the company is being honest about its financial information. If it's not, it could be charged a bunch of money by the Securities and Exchange Commission (SEC)…and it will probably get plenty of bad press.

But just because a company has filed all the right paperwork with the SEC and has passed the test at the New York Stock Exchange, it doesn't mean that it's guaranteed a winner. You can still lose money on the stock if the company suddenly takes a nose dive—it happens all the time. But having all those filings and all that financial information can at least help you make a better decision about which stocks to buy.

Here are the three pieces of information that you'll want to take a look at.

Balance Sheet

A balance sheet gives you a peek at the net cash and assets a company has.

If you were to start an online business selling photos of dust bunnies (no judging), your balance sheet would include the following:

  • The $2,000 you got from your dad to start the business
  • The $1,800 you spent on a used computer, web hosting, and a camera for the business
  • The $200 in cash leftover
  • The $1500 you think you'd get if you sold the equipment tomorrow
  • Your residual value plus cash assets: $1700 (assuming you have no debt)

Cash Flow

Cash flow simply refers to the actual money coming into your business. This set of numbers shows you how a business is doing over time in operating profits.

Let's say that your dust bunny photo company has been in business for two months. In the first month, you spent $20 for online services to keep your business going, and you sold $30 worth of photos to some people who really hate to dust. That month, you made $10 in pre-tax operating profits (we're assuming you're not paying yourself a salary yet). The next month costs the same ($20) but you made $100 in sales. Your profits are now $80 (pre-tax).

If you keep growing operating profits at that rate, you'll be doing great. Dust bunnies unite!

Income Statement

An income statement tracks money coming in and out of your business, as well as intangibles like depreciation. It can even go into the future to predict future expenses.

An income statement looks a little like the cash flow statement, but it's more like its older sister. You'll still list the $80 in profits you made last month, for example, and your monthly expenses. But you can add depreciation of your equipment. Since time has passed, your camera and computer equipment might only have a residual value of $1,000. Maybe you need to plan for a photographer's convention two months from now. That will add to your expenses, and you can use the income statement to plan for that.

If you're trying to invest in a company, these three pieces of information can help you decide how much of a risk it might be. Does the company have slow cash flow (not a lot of money coming in)? Does the company's income statement show high operating expenses or lots of debt? Does the balance sheet suggest the company has very few assets?

Other Stuff to Consider Before You Buy

All the annual reports and SEC filings in the world can't predict the future.

Will the CEO resign tomorrow and be replaced by his trust fund baby son who doesn't know how to run the company? Is the company going to go into debt a month from now to buy a sinking company that's going to push them into bankruptcy?

There's no way to really know.

So in addition to taking a look at SEC filings and financial information, you'll want to do the following:

(1) Consider the reputation of a company.

Does this company get tons of complaints from unhappy customers? Is the company known as being the best in its field? Reputation isn't everything (and it can change), but when a lot of customers are happy with a company, they are more likely to keep buying from that business and making its stockholders very happy.

(2) Take a look at a company's past and future ideas.

What's been happening at the company? Have they hired or fired new managers, presidents, CEOs? Is there a shakeup going on? Has the company been developing good products over the years, or have they launched a new product recently?

(3) Consider whether you support the company.

A good way to consider whether a company is good news is to ask yourself if you'd do business with them. Check out your closet, garage, and house. What brands do you buy? Why? If you turn to the same brands again and again because they sell good, dependable products, chances are other people are doing the same thing. Over time, that kind of good business means decent profits for the company's owners (which could include you, if you buy stocks).

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