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Author: TMFSelena Big gold star, 5000 posts Old School Fool CAPS All Star Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 27482  
Subject: How to "do your homework" Date: 7/3/2006 6:08 PM
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Greetings, folks! On another board, I answered someone's question about how to go about "doing your homework" in investing. I thought that some here might get something out of my response, so permit me to cross-post it here.

Selena


<<what does it mean when an investor does or doesn't "do their homework"?
>>

Well, that's a big question. Basically, you just shouldn't buy or sell without doing some research on the company in question, and in general, the more research the better. Of course, it can take a while to learn what to do and how to do it, but we can all start at the beginning and keep learning and adding to our arsenal.

Below are some snippets on the topic, drawn from our newspaper feature.

Best wishes!

Selena


Analyzing industries

Before considering any company as a possible investment, it's smart to study its industry. In his book "Competitive Strategy" (Free Press, $37.50), Harvard Business School professor Michael Porter laid out five competitive forces that affect an industry.

-- Threat of entry. Evaluate how much capital it takes to enter the industry, the economies of scale, switching costs, and brand value. It's easier to enter the lawn service industry than the semiconductor equipment industry -- one requires some relatively inexpensive equipment, while the other requires factories and much specialized knowledge. Switching costs protect companies, too. People will think twice about switching e-mail providers because they'll have to alert too many people of their new address.

-- Bargaining power of suppliers. There are only a few airplane suppliers (such as Boeing and Airbus), so if you're running an airline it's difficult to play one against the other, trying to strike a bargain. If there were many suppliers, they'd likely be competing more for your business, which might result in lower costs for you.

-- Bargaining power of buyers. This is affected by brand power, switching costs, the relative volume of purchases, standardization of the product and elasticity of demand (where demand increases as prices fall, and vice versa). When buying electronics, for example, consumers have many choices and can compare many prices online. This gives them bargaining power.

-- Availability of substitutes. If you're in the restaurant industry, your business will be affected by how easily people can buy take-out meals at supermarkets, how many people prepare meals at home, and the availability of other alternatives.

-- Competitive rivalry. The more competitive an industry is, the more likely you are to have price wars and reduced profitability. The airline industry is a good example here. Over the years it has not offered the best returns to investors.

Consider factors such as these and you might learn that an industry just isn't as attractive as you thought. Get more investing insights in "The Future for Investors" by Jeremy J. Siegel (Crown Business, $27.50).

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Price and Quality

To maximize your investing results, you need to find promising companies, evaluate their health and prospects, decide whether and when to invest in them, and then whether and when to sell. Underlying all those steps are two questions that you need to be able to answer about any of your investments:

1) Is this a strong, high-quality company?
2) Is the company's stock priced attractively or not right now?

If you don't address both questions, you might end up buying grossly overvalued shares of a wonderful company or you might snap up shares of a hapless, doomed business at what seems like a bargain price. Investors have lost bundles doing either or both of those things.

The first question is much easier to answer than the second. An enterprise such as Coca-Cola or Johnson & Johnson or Avon might quickly appear to be a first-rate firm. But at what price is it a good buy?

Some investors believe that as long as you've got a tip-top company, the price isn't that important. They figure that if an overvalued company keeps growing, it'll eventually grow into and surpass its price. (This can happen, but it might take a long time, and sometimes it doesn't happen.) More conservative investors recognize that buying at an attractive price is vital to reduce risk and maximize gain.

Conveniently, most company evaluation measures are related to either quality or price. Quality-related measures reflect a firm's profitability, growth, and health. They include sales and earnings growth rates, profit margins, return on equity (ROE), return on assets (ROA), inventory turnover, market share and management quality, among other things.

Price-related measures help you determine whether the stock is overpriced, underpriced, or priced just right. They address a company's valuation or stock price and include market capitalization, enterprise value, price-to-earnings (P/E) ratio, and price-to-sales ratio.

Keep both quality and price in mind as you examine possible investments, and your portfolio will thank you. Learn more about how to crunch these numbers in our "Crack the Code" How-to Guide at www.fool.com/shop/howto and also at http://stocks.about.com/od/evaluatingstocks.

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How to Research Companies

Before you plunk any hard-earned dollars into a fascinating company you just discovered, you need to do some homework. Below are the kinds of questions you should ask about any potential investment. (Don't be intimidated or discouraged by the list that follows. You needn't master everything at once. Beginning investors should just keep learning slowly. We can help you at www.Fool.com, and you can learn a lot from books by experts such as Peter Lynch.)

-- What business is the company in? What's its business model (that is, how exactly does it make its money)? Is it in a profitable, growing industry?

-- What's the company's track record? Has it regularly rewarded shareholders? Have revenues, earnings and profit margins been increasing in past years? How do these numbers compare with those of competitors?

-- What's discernable from its financial statements? Has the company's debt level been rising or falling? Are accounts receivable and inventories rising no faster than revenues? Are profit margins healthy and, ideally, growing? How about return on equity (ROE), return on assets (ROA) and other measures? Are there any red flags to worry about and investigate further? Is anything in the statements unusually cryptic? (It's often best to steer clear of companies you don't understand very well.)

-- What's the company's competitive position and strategic vision? Does it have a strong brand? Is it a leader in its field? Is it gaining market share? Do you have confidence in management -- and its ability and dedication to keep the company growing, to be straight with shareholders, and to look out for their interests?

-- What are the risks that the company and its investors face?

-- Is the stock valued attractively? This is a difficult question to answer for any stock, and there's usually no one right answer, either. You might begin by looking at the company's current P/E ratio, comparing it to the firm's historical numbers.

Next week we'll offer some resources to help you answer these questions.

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Resources for Research

Below are online resources that can help you determine how healthy and promising a company is as a possible investment.

Note: If you don't own a computer, make use of your local library, and perhaps check out "Fire Your Stock Analyst: Analyzing Stocks On Your Own" by Harry Domash (Financial Times Prentice Hall, $25) or " One Up On Wall Street: How To Use What You Already Know To Make Money In The Market" by Peter Lynch (Fireside, $14). Many libraries also offer Internet access, permitting you to check out the websites below.

-- The company's own website. Look for links labeled "About Us," "Corporate Information," "Investor Relations," etc., and try to read at least the most recent annual report. Search engines such as Google.com can help you find a company's website. Look up company ticker symbols at http://finance.yahoo.com/l.

-- Financial data and research providers, such as http://finance.yahoo.com and http://quote.Fool.com. All financial statements that companies must file with the Securities and Exchange Commission (SEC) are available through sites like Fool.com and Yahoo! and also at www.sec.gov/edgar.shtml.

-- Analyst research reports. Your brokerage may provide you with these research reports for free. You can also read analysts' thoughts on many firms via our newsletters at www.fool.com/shop/newsletters and Morningstar's, at www.morningstar.com.

-- Historical P/E ratios and other measures. Look these up at http://moneycentral.msn.com/investor/research/welcome.asp. This can be very handy. If a company you're examining has a P/E of 20, for example, and you see that over the past five years its P/E has usually been around 30, then you might be looking at an attractive price right now.

-- Insightful articles on companies that interest you in current issues and archives of financial periodicals. These include The Wall Street Journal, Investor's Business Daily, Fortune, Forbes, BusinessWeek, SmartMoney, Barron's, The New York Times' business section, The Economist, etc. Check your local newspaper's business section, too. Also useful are http://news.google.com, www.findarticles.com and www.highbeam.com.

-- Industry information. Research an industry and learn about a company's competitors at these websites: www.virtualpet.com/industry/rdindex2.htm and http://biz.yahoo.com/research/indgrp.
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