Evaluating Companies

This is truly where the rubber meets the road when it comes to investing. Ask most people about their favorite investments and they will quickly rattle off a list of companies they believe to be great investments. However, ask them why they believe the companies to be such great investments and the conversation gets a bit fuzzy. Most will tell you it’s because the company and its products are great, or that the stock’s price is climbing and that there is no end in sight, or that they have simply owned the stock for so long that they forgot why they purchased it in the first place.

The problem for most people, however, is that they simply do not understand how to dissect and evaluate a company’s financial statements. Start talking numbers and the eyes of a vast majority of people begin to glaze-over. The good news, though, is that financial statements are not that difficult to comprehend once you have a basic understanding of how to read them.

Some basic terms with which you you will want to become familiar are:

  • Gross Profit
  • Earnings Before Interest and Taxes (EBIT)
  • Earnings Before Taxes (EBT)
  • Net Income
  • Earnings Per Share

Basically, gross profit is the difference between the cost of goods (or services) sold (COGS) and sales. In other words, if a company makes widgets at a total cost of $2.00 per widget and it sells them for $10.00 apiece, then the company’s gross profit equals $8.00 per widget. Using the same example, if you deduct operating expenses (i.e. things such as employee salaries, copy paper and utility bill payments) you arrive at earnings before interest and taxes, or EBIT. Going a step further, if you remove interest (i.e. the additional funds a company must pay for the money it borrows) you end-up with earnings before taxes (EBT). And, finally, subtract taxes and you arrive at that all important net income number — the number used to calculate the coveted earnings per share (EPS) figure that so many analysts watch (a figure individual investors should watch as well).

So, using our example above, if the company’s operating expenses are $2.00, the interest payments are $1.00, and its total tax expense is $1.00, then the company’s net income will be $4.00 per widget. Divide the net income by the total number of shares outstanding (let’s say four) and you arrive at earnings per share (or, in this case, $1.00 per share).

Once you have the EPS figure, however, the analysis does not (and should not) end there. You need to compare the figure to past performance (i.e. year-over-year (YOY)) and to the performance of other companies within the industry to see if the company is competitive. Doing so will give you an idea of whether or not the company’s position is improving — both, against its historical records and against its competitors.

Bottom Line: You need to employ the same critical thinking you would use to analyze your own finances when analyzing your investments. Doing so can prove to be the difference between a healthy portfolio or heartache over incurred losses.

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