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 during the next few years, then 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. 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 past 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 a dollar in a sluggish economy has given the company record-breaking profits each year for the past five years -- and a stock price that has soared nearly 360% since.
|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.
|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.
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 Stores (Nasdaq: ROST) have managed to grow their net incomes for the past three years and both stocks have returned more than 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 should have 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 1.0 times 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 is a signal that the company's stock is trading at a fair price or even a bargain.
Action to Take --> 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.
This article originally appeared on InvestingAnswers.com:
The 8 Most Important Facts To Know About A Company Before You Invest