Nine questions to ask before you buy

It pays to do a little work before investing in stocks. These are the nine questions you should always ask before buying shares.

According to studies conducted in the 1990s, "the average investor devoted more time to researching his next vacation" than his stocks, says Janice Revell in Fortune. It seems that instead of doing any actual work, "we'd rather just roll the dice" on our finances. This is absurd, not only because it is a sure-fire way to lose money, but also because a little time and effort can "take a lot of the luck out of investing". All you need to do is consider the questions below. They may sound simple, but answer them before you buy and you will be an investor, not a gambler.

1. How does the firm earn money

This sounds basic, but the answer is not always obvious. Take GM. It sells millions of cars every year, but that's not where it makes money. Instead, nearly 100% of profits come from its financing arm and only 50% of that from car loans. The rest comes from mortgages. None of this makes GM a bad firm, but it is the kind of thing you should know before you buy. Do so by looking in the annual report for the description of a company's business units and the sales and earnings that come from each.

2. Do those earnings really translate into cash?

Much of what companies report as earnings is really "based on guesswork", says James K Glassman in the International Herald Tribune. Baruch Lev of New York University, "one of the top accounting scholars in the world", recently said that his research shows that reported earnings are "widely manipulated" and investors are "systematically deceived". That means that to see the truth you must look at the the firm's cash flow - the amount of real money coming in and out of the door. "Earnings are an opinion," the saying goes, "Cash is a fact." To find out what is going on with cash, look at the "cash flow from operating activities" line in the cash flow statement, says Revell. Is it positive or negative? Growing or declining? Then check for "this red flag": are net earnings rising but cash flow falling? That often means "creative accounting".

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3. How do sales look?

Many investors dismiss looking at sales numbers as "brutishly simplistic", says Glassman. They should think again. If sales are rising a business is usually doing pretty well, even if it isn't yet reflected in earnings. But a business that isn't seeing rising sales won't see rising cash flow for long. Indeed, research published in 1995 showed that the best ratio to use when stock picking between 1952 and 1994 was the price to sales ratio (P/S), calculated by dividing a firm's market capitalisation by its revenues. Over the period studied, the 50 stocks with the lowest P/S ratios produced average annual returns of 18.9% against 14.6% for all shares. You shouldn't use P/S ratios in isolation (a very low one suggests an expectation that sales will fall, for example), but they should be part of your tool box. A word of caution, says Revell: some firms book revenues "long before the cash comes in the door". Those aren't real sales.

4. Why the writedowns?

In a firm's history, occasional writedowns and restructurings are inevitable, says Revell, but if you see them year after year, alarm bells should go off as too many make it "practically impossible to see how profitable a firm really is". For example, in the years leading up to its bankruptcy, Kmart repeatedly took charges. Investors should have seen that as spelling bad news.

5. What could kill the firm?

Before you invest "you must give some thought to the worst-case scenarios it may face". If it is dependent on only one customer, for instance, it is vulnerable to losing that customer. Take fibre-optic maker Sycamore Networks. When it went public in 1999, anyone who read the prospectus could have seen that it had only one client, Williams Communications. No surprise, then, that two years later, when Williams collapsed, so did Sycamore's sales. Watch too for firms that are dependent on the input of just one person: shares in Martha Stewart Living Omnimedia are down 50% since Stewart's "legal woes" began in June 2002.

6. How is the firm doing relative to the competition?

Look at how sales are growing year on year, says Revell. If the firm is in a growth industry, are they growing as fast as rivals? If it is in a mature industry, are sales holding their own?

7. How does the broader economy affect the firm?

Many stocks are highly cyclical in that their performance is tied to the economy. When the economy is on a downswing, for example, shares in paper companies can look cheap. But there is good reason for this: in tough times advertising falls and the demand for paper falls. Interest rates have a huge effect too - recently, falling rates have resulted in a wave of home refinancing and consumer spending to the benefit of homebuilders and retailers. But rates aren't going any lower now, so these firms will now see growth rates fall. Also consider currencies - companies that export a lot benefit from a weak domestic currency, those that import a lot suffer, says the FT.

8. How much debt is there?

Even if things look good today, that may not continue if a firm has run up "a gargantuan pile of long-term liabilities". This cuts its available margin of error and greatly increases its sensitivity to interest-rate rises. To see if a firm is overloaded, divide long-term debt by total capital (debt plus shareholders' equity) and see the balance sheet for both numbers. If the answer tops 50%, "there is a strong chance the company is borrowing beyond its means".

9. Are the shares worth the price?

As Warren Buffet points out, people will rush to buy anything at a discount, except stocks, says Revell. All too often they seem to prefer shares to rise before they buy. But "the greatest company in the world can make for the lousiest investment if you pay too much". Also, always look first at the p/e ratio: most fund managers won't pay more than 30 times earnings for a share even if it is in a growing industry. Another "quick and dirty" ratio worth looking at is the PEG ratio, says Glassman. This is calculated by dividing a firm's p/e by its estimated rate of earnings growth. It is far from a perfect measure, but a rule of thumb is that a PEG of less than 1 signals that a stock may be offering growth on the cheap.