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Welcome to the Investing Section of Options Realm |
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Recently I have been reading many web forums and the same questions seems to arise almost daily. That question is how does one go about picking a stock and where do you begin. I figured that this would be a good opportunity to write an article about what one needs to know about stocks and how I go about picking stocks. The first thing that I feel needs to be established is to define what exactly you are getting when you buy a stock. The purchase of a stock is like buying a portion of a company. To give an example lets assume that the local news store owner decides that he wants to sell a portion of his business to raise money to expand the store. He decides that his store is worth $100,000. He decides that he want to sell half of the store in order to raise money. So he breaks the company down into 1,000 blocks and sells 500 blocks to local residents for a price of $100 a block. This process raises $50,000 for the store owner and gives a part of the store to each resident who bought a block. This is the same concept that applies to the stock market. Each share that is sold is a small block of that company. To understand stock picking we must understanding where the value on each share comes from. Now that we know where the value comes from we can start to investigate how to know how much these companies are worth. Right away there are many things that an investor can look at to get a rough idea what the company is worth. Some things that you can find out from just checking yahoo finance is what the income of the company is. From there you can also see what the Price to earnings ratio is for each share. By click around even more on yahoo you can find out how much the company is expected to grow. After all these things you then can look at how much debt the company has and how much cash the company has on hand. While all these thing are good to know what can we actually use them for? Well, one way to value a company is to look at how much their present and future incomes will be worth and then using that figure out how much the company is worth. But this method has a flaw. While earnings are interesting they only tell half of the story. If a company is earning 50,000 dollars in profits but are then turning around and spending 60,000 dollars in keeping their machinery up to date we can see that this process is not actually building value to the company. In order to combat this most people like to look at Free Cash Flows when valuing a company. Free Cash Flow can be found on the balance sheet of every company. In order to see how much money a company is actually making you want to take Free Cash Flow and subtract it by capital expenditures, also found on the balance sheet. Now that you have the amount of money the company is actually making you can find a very interesting ratio. The Price to free cash flow ratio. To find this you take the number of shares and divide the cash flow number by the number of shares. Then take that number and divide price by it. Then you will get the P/FCF number. This number is very important to making sure a company is not severely overpriced. In the next stock article I will be talking about how Return on Invested Capital or RIOC and growth are very important factors to a company. |
