Shareholders
frequently ask: "How do the portfolio managers of mutual funds
decide which stocks to buy?" The answer: homework - lots of
it.
Different Strokes for Different
Folks
When investors look at a stock, they can go through different
processes to see if it might be a promising investment. Some
portfolio managers use fundamental analysis to help decide if
they should invest in a company. This means they study basic
information about the company. They examine its balance sheet
and income statement to get an idea of its financial strength.
They also look at its earnings history and growth rate. It can
also be helpful for them to talk to industry analysts about
the company's management. Finally, they check out its products
and market position. Portfolio managers are looking for clues
about a company's long-term financial health that can help
them make decisions about the company's growth potential.
Where to Look
One place to start the search for clues about a company's
financial health is in its annual
report. This document provides detailed information
about the company's economic condition and what the company
did in the previous 12 months. Two of the most helpful items
in the annual report are the balance sheet and the income
statement.
The balance
sheet offers
a "snapshot" of a company's financial health at a specific
point in time. It reports all the company's assets (what it
owns) and liabilities (what it owes), and shows how these have
changed since the end of the previous year. This report is
called a balance sheet because the asset side of the ledger
must equal - or balance with - the liability side.
The balance sheet
helps investors determine if the company has enough assets to
pay both its short- and long-term bills. The balance sheet
also shows the value of all the stock owned by shareholders.
In addition, it shows the amount of profits that have been
reinvested in the company.
Another important
financial table found in annual reports is the income
statement. The income statement adds up all income,
subtracts expenses and shows how much money is left to
reinvest in the company.
Show me the Clues!
A company's income statement and balance sheet can help you
decide whether to invest in its stock. Here are some clues to
look for:
Earnings per share (EPS).
You can find EPS on the income statement. EPS shows you the
company's profits per each share of common stock. A company's
earnings-per-share information is used to determine a stock's
price-to-earnings ratio. When portfolio managers look at a
stock's EPS, they are examining how it changes from year to
year. They like to see a stock's EPS growing at a steady rate.
Shareholders' equity. Using
the balance sheet, subtract the company's total liabilities
from its total assets. The amount left over is the total value
of the shareholders' investment in the company. Shareholders'
equity is used in finding the company's debt-to-equity ratio
and its return on equity.
Debt-to-equity ratio. The
balance sheet also can help you find this measure of a
company's financial strength. You find this ratio by dividing
the company's total liabilities by the total shareholders'
equity. In general, the lower the ratio, the stronger the
company.
Return on equity. You find
this important measure of a company's ability to make a profit
by using both the balance sheet and the income statement.
Simply divide total shareholders' equity by the company's net
income after taxes. Comparing this number from year to year
reveals trends that can tell investors how well a company is
using its investments.
In general,
portfolio managers of mutual funds use these and other clues
to help locate companies that they believe will be good
investments for their particular fund. Usually, such companies
have a high return on equity, a low debt-to-equity ratio and,
hopefully, the ability to grow earnings each year. Of course,
just because a company has these qualities doesn't mean it
will continue to do well. But this information can help
investors make knowledgeable decisions. |