How to Evaluate a Company Before You Invest: Balance Sheets
Investors have a funny habit of believing everything that Mr. Market tells them.
They’ll put money into a stock just because they see its share price start to climb. Or because they’ve read a news headline that makes the company sound like a good investment.
But most of the time, they have no clue what the company’s financials actually look like.
So they end up putting their hard-earned money into a business that’s bleeding cash and has one foot in the grave.
I don’t want this same scenario to happen to you.
So, in this week’s update, I show you how to look at a company’s balance sheet and determine if the business is a contender or a pretender.
I walk you through every important number you need to know. And I show you a real-life example of what a healthy business looks like.
You don’t need a Ph.D. or a math degree to figure out if a company can afford to keep its lights on.
All you need to do is follow these simple steps that I lay out for you.
Doing so will safeguard your portfolio — and help you lead a happier and richer life.
Check out the complete details in my seven-minute video below…
Your Road Map for Successful Investing
Over the past few weeks, I’ve walked you through my approach for finding healthy and profitable companies.
I showed you how every stock you buy is really a piece of a business.
And I revealed a simple — and free! — way to evaluate any publicly traded company before you add it to your portfolio.
After watching this week’s video, you now know how to read a company’s balance sheet to determine if its business is financially sound.
Put it all together, and you’ve got a road map for identifying safe investments benefiting from long runways of growth.
These are the same steps I walk readers of my Alpha Investor Report service through.
Each month, my team and I tear through a list of potential stock investments. We look at each company’s products and services, and dig through their financials.
Then I take my 35 years of experience and find out which of those businesses is trading for a bargain price before recommending it to my readers.
So far, of the 11 monthly recommendations I’ve made in the past year, 10 of the stocks are trading in positive territory.
More importantly, my readers are having fun and learning how to invest beyond Wall Street’s noise.
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And the other week, Stuart A. wrote:
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If you’d like to get all my investing insights alongside Reza and Stuart — and learn how to identify mispriced stocks poised to soar higher — click here for details on how to subscribe to Alpha Investor Report today.
This is part 3 of a 3-part series on investing. You can review the rest of the series here:
- Part 1: How To Buy Stocks in 2020.
- Part 2: How to Evaluate a Company Before You Invest.
How to Evaluate a Company Before Investing
When you buy a stock, you’re buying a piece of a business.
And it always blew my mind that investors — who will look 58 times at every single document before they open up a frankfurter stand — never even think twice about investing their hard-earned money into a stock, which is nothing more than a piece of a business.
And the question that I can’t figure out is: How come so few investors look at the financials before investing? Why aren’t we analyzing a balance sheets?
Because no matter how great a business seems to be, no matter how great the story is … if the company is losing money, bleeding capital, burning cash and has one foot in the grave, what’s the long-term viability of this business?
That’s why I’m going to show you what numbers to look for, and where to find them, which is an integral step in understanding how to evaluate a company before you invest.
Recap: The 3 Knows
Before I make any investment, I always ask myself, do I know the 3 Knows? And that is … Do I know the business? Do I know the product or service? And do I know the numbers? Because if you don’t know all three, you’re really at a severe disadvantage.
The best place to look for all this information is the SEC (Securities Exchange Commission) 10-K.
Every public company in the country has to put out a 10-K with the SEC, and they file it on their website. It’s a great source, and it’s free.
This is the information the company has to tell you — not what they want to tell you. They throw the kitchen sink and everything else into this. And that’s why I love researching companies through the SEC website. You’ll find all the information you need to know about a company, right there.
In the video series above, I share with you the third of the 3 Knows, which is: Know the numbers. In the previous two, I shared with you how to look at the business and the product or service. This one is extremely important, so listen clearly…
The No. 1 thing I want to look at in a business is this: Is the business financially sound?
And for that, I analyze the balance sheet.
How to Analyze a Balance Sheet
The balance sheet is nothing more than a statement of assets and liabilities. In other words, it shows what the company owns, and what they owe.
Now think about this for a second … If a company can’t pay the rent or can’t pay their workers or can’t pay vendors, it doesn’t matter how good sales are or how great the business seems.
Look at what happened with WeWork and a whole bunch of other companies in the past year. They had great stories and they were doing great sales, but they were losing money and the liquidity was drying up. They eventually ended up in the dustbin.
Keep in mind, whatever I show you here now is not a one-size-fits-all. There is no one perfect way to determine financial health. Each industry is different. However, there are one or two commonalities that every industry has, and that’s what I want to share with you today.
So one of the ways that I look at a business is to see if it’s liquid. Does the business have assets? Does the business have enough assets on hand to pay their liabilities?
And for that, I look at what’s called the “current ratio.” The current ratio is the company’s current assets to their current liabilities. That’s it. Doesn’t get more complicated than that.
Current assets are assets they can turn into cash within 12 months or less. Current liabilities are liabilities that they have to pay within 12 months or less. That’s it.
In terms of liquidity, I want to find companies that are able to keep the doors open and have enough assets in order to pay off their liabilities. For that, I look at the company’s 10-K. I go to the SEC site.
And like I said: In the description below, I have a link to my previous one which will show you exactly how to find all this information…
When you get to the company’s 10-K, click down to item No. 8.
That’s where all the financials are. So let’s take a look at Microsoft — just as an example.
If we look at Microsoft’s balance sheet, we see a company that has total current assets of about $175 billion. And if you go a little lower on the balance sheet, we look at the company’s total current liabilities and they roughly run $69 billion.
Now, the current ratio just looks at the current assets to the current liabilities, and does the ratio of them. So we take the current assets to the current liabilities to get the current ratio.
For Microsoft, all we need to do is take the current assets of $175 billion or so to the current liabilities of around $69 billion. And we get a current ratio of 2.5. What does that mean? Simple. For every $1 in current liabilities, Microsoft has more than $2.50 in current assets. It’s that simple.
So this is a company with a lot of liquidity. In fact, so much liquidity that they can pay off all of their liabilities without any trouble at all. As just a short hand, you want to avoid companies that are less than 1.0 in terms of their current ratio, which basically means that the company’s debts that are due in a year or less are greater than the assets.
Avoid those companies that are below 1.0. Buy the companies with ratios above that. Those are companies that are more capable of paying off short-term liabilities.
Keep in mind, the best way to do this is to compare the same company with its own industry. So if you’re looking at retailers, compare retailers to retailers, then find the strongest one in their industry. This is just a shorthand. It’s a way of avoiding disaster — not so much a way of finding the best companies. Because there’s always going to be exceptions to the rule.
It’s a great starting point. Keep in mind, you’re investing in a business. The more informed you are, the better decision-making process you’ll have, the more money you’ll make. And, more importantly, you’ll know what to avoid.
Now, in each issue of the Alpha Investor Report that I write, I tear through the 10-Ks. I learn everything about the business and the product or service, and then I go through the numbers. I then take my 35 years of experience and I find those businesses when they’re trading at bargain prices.
I put a link in the description below to order the newsletter. It’s a fantastic piece. Every month I highlight one company.
But with the information I gave you today, you’re well on your way to be a much better and more informed investor. And a more informed investor makes more money. It’s that simple.
Editor, Alpha Investor Report
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