The 8 Most Important Facts To Know About A Company Before You Invest

By Christian Hudspeth
December 21, 2012

Investing in a stock isn't throwing your money into a poker pot and betting you'll magically become rich overnight. 

When you "buy" a stock, you're not buying a piece of paper -- you are becoming an owner of the company that stock represents. 

If you buy, for example, stock in Apple (NASDAQ: APPL) and profits grow for the next few years, you'll be treated to a rising share price and grow wealthier along with your fellow owners. But if you invest in Apple and the company does poorly over the next few years, your shares will lose value -- and you'll lose money on your investment.

While this concept may sound simple, it's surprising how many investors overlook key indicators about a company before they invest. As a result, they become owners of lousy companies that lose money year after year.

You want to be an owner of a successful company that gives you a return, so why wouldn't you take some time to research it first?

Don't worry, it's easier than you think. Using just eight key terms and spending 15 minutes to analyze a company can mean the difference between reaping healthy investment gains and losing your shirt

Straight from the InvestingAnswers Financial Dictionary -- the industry's most investor-friendly resource used by hundreds of thousands of investors every month -- here are eight key financial terms that will make you a more successful stock investor.

And for a more detailed explanation of each term -- including examples, formulas and more -- just click on it.

1. Chief Executive Officer (CEO)

Like a ship captain, a company's executive officer steers, rights and can sometimes sink the ship, so it's important to know a company's CEO before you buy.

What to look for: You don't need the CEO's biography, just a brief overview of their business background (Morningstar can help with this -- here's Apple CEO Tim Cook's overview, for example). Ask yourself things like: Do you believe the CEO has the right experience to run a car company for the next 10 years if he ran a retail chain before for the last 10 years? Is the company's success heavily tied to this person like Steve Jobs was to Apple or Warren Buffett is to Berkshire-Hathaway (NYSE: BRK-B)? And if so, do you feel comfortable that the business can do well after that person leaves the company?

2. Business Model

A business model is essentially the strategy that a company uses to maximize its profit in its industry. 

Wal-Mart (NYSE: WMT), for example, offers the lowest possible price so it can sell more products. By contrast, another retailer like Coach (NYSE: COH) sells fewer, higher-quality items but earns a larger profit per product sold.

What to look for: While there is no "right" strategy, be sure you understand and agree with the company's business model. Think about how well the company's business model might work in recessions or economic booms. Dollar Tree's (NASDAQ: DLTR) business model of selling products for just $1 in a sluggish economy has given the company record-breaking profits each year from 2007 through 2012 -- and a stock price that has soared 352% over the same period.

[Note: Some companies' business models are more difficult to pinpoint. Sound, unbiased financial newsletters (such as the financial newsletters offered by our parent company, StreetAuthority) can give you great insight on how a company profits and rewards shareholders, but you can find brief outlines of a company's business model on Morningstar -- as an example, here's Dollar Tree's profile.]

3. Competitive Advantage

Sometimes called an economic moat, a competitive advantage is when a company has a leg up over its competitors through its superior products, patents, brand power, technology or operating efficiency.

What to look for: Be sure the company you're thinking about buying has a competitive advantage. For example, Wal-Mart offers super-low product prices that are hard for competitors to beat. Coca-Cola (NYSE: KO) has strong brand name recognition and sells a popular product that's hard for competitors to replicate. A competitive advantage is the wall that keeps competitors from taking market share and keeps that company more profitable -- and makes it a better investment for you -- over the long term.

4. Revenue

Revenue is simply the raw amount of money the company made from sales of its product or service. Revenue is sometimes called a company's "top line" as it's always listed as the first line of every company's income statement. [See where to find an income statement and an example of one here.]

What to look for: A company with its revenue trending up each year for the past few years. While it's not realistic to expect a company to increase its sales every single year (especially in a struggling economy), a company with a trend of falling annual revenues signals it has trouble selling its products and services or finding other sources of revenue.

5. Net Income 

More casually called profit, earnings or "the bottom line," net income is simply the amount of money a company earned from sales after expenses and taxes have been paid. As its nickname suggests, you can find a company's net income listed on the bottom line of the company's income statement.

What to look for: Net income growth from year to year. A company with growing net income each year shows that the company knows how to effectively sell its products, slash or control its business operating costs or a combination of both. Companies like AutoZone (NYSE: AZO) and Ross (NASDAQ: ROST) have managed to grow their net incomes for the past three years, and both stocks have returned well over 100% during the same period.

6. Profit Margin

Profit margin (sometimes referred to as net profit margin) is simply the percentage of revenue the company takes in as profit (after expenses, interest and taxes have been paid). Apple, for example, has a profit margin of 26% -- for every $100 iWidget it sells, it makes $26 profit. A company's profit margin is net income divided by total revenue.

What to look for: A company with steady or growing profit margins every year, even during a recession. Companies with growing profit margins signal that the company can command higher prices because consumers are willing to pay for their product (Apple enjoys healthy profits because it can sell its devices for a much higher price than competitors). Companies that can maintain steady profit margins show the company can effectively control its operating costs, keeping the company efficient (Wal-Mart has been able to keep its product prices low and its profit margins steady even through recessions). Steady or growing profit margins ensure that a company is profitable and can reward shareholders with returns.

7. Debt-to-Equity Ratio

With the debt-to-equity ratio, you can find out how much debt a company carries compared to the amount of equity shareholders have in the company.

What to look for: A company with a low amount of debt in relation to its equity (total debt levels that are no higher than the company's total equity levels; a ratio of 1:1 or lower). Used as a safety measure, it tests how well the company can repay its debt obligations in the event that the company runs into serious financial problems. Generally, the lower the debt-to-equity ratio a company has, the less risky it is to you as an investor.

8. Price-to-Earnings Ratio (P/E)

Finding a company with strong financials is not enough. Just like you can pay too much for a great car, you can pay too much for a great company -- and that can mean limited upside potential on your gains (and even a loss). With a stock's price-to-earnings ratio (P/E), you can find out if a stock is overpriced. The P/E ratio compares a stock's price to the amount of profit per stock share (earnings per share) the company generated.

What to look for: A company with a P/E ratio that is on par with or lower than the overall market's P/E ratio (which has historically been between 14 and 17) and the company's peers in the industry. In general, a well-run company with a relatively low P/E ratio signals that the company's stock is trading at a fair price or even a bargain. [Warren Buffett uses this "value" investing approach and has been wildly successful. Learn more about this strategy in Warren Buffett's Golden Rule of Investing.]

The Investing Answer: While these terms won't guarantee success with stock investing every time, they will help you avoid the pitfalls that less experienced and even sometimes veteran investors run into. Find companies that a) you understand and agree with from a leadership and business perspective, b) operate with strong management and financial health and c) are trading at a good value. These will be key to your investing success.

Happy Investing!

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