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How to Select a Stock to Keep? Part 3 of 3

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adboard You have acquired the basic knowledge of investing. After which you have selected a few filters to whittle the list of stocks to follow to a few manageable ones.

Now, it gets harder.

Step 5

If you have done the previous steps correctly, you would have a list of stocks with the different criteria of price to tangible book and return on equity.stocklistexcel

Your Excel file will look something like this list of 42 stocks.

I have sort it by price to tangible book to find stock whose prices are depressed and are cheap relative to its tangible book.

Next, I scan through the list of stocks with less than 1 in the price to tangible book and look at the Return on Equity (ROE) column to pick out the most promising stock to look at. It turns out that it is Golden Agri-Resources Ltd.

Step 6

Next, it is time to look more carefully at the company's financial statements:

The first thing to look at is the auditor's report if you can get hold of their annual report. If the auditor's submits a qualified report or an adverse report, it means that the auditor disagrees with the method or way the financial reports are being prepared. It is one warning sign that there are some financial shenanigans going on in the company.

Another is to look in the auditor's report to see whether the auditor issues a 'going concern' alarm bell. It just means that the auditor feels that there is a possibility the company may go belly up.

A caveat to note is that we live in an age where these annual reports that tell us the company financial statements may not be totally accurate or even truthful. Witness the Enron and WorldCom debacles and the fall of the audit firm Arthur Andersen. You can download and read in more about the different frauds at this powerpoint slide "Financial Statement Fraud."

Step 7

We come next to the place where the more hardworking investor must trudge through.

I remember reading that in Warren Buffett's office, you don't see computer screens with Bloomberg running their tickers and tracking the moving indices. Instead he is more likely to be bent over looking at annual reports looking for the next company to invest. 

These are the two basic things to focus on in the reports:

    1. the balance sheet
    2. profit and loss statement or income statement.

The items to look at includes the past year's figures so that you can make a good appraisal of the company's prospects. A good figure will be at least 5 to if possible 10 years. Basically it is a quick scan through of the items to look for something extraordinary like a big unexplained jump in the figures.

You also need to look at these items within the reports:

    • balance sheet
      • current assets (what the company has)
      • current liabilities (what the company owes others)
      • net asset/liabilities or current asset/current liabilities or current ratio
    • Income statement
      • gross profit
      • income from operations (has the bulk come from operations or other activities, it could mean management is spending too much time on speculating in properties, investment or other non core activities)
      • net income (has the figures been increasing over the years, or is the company showing starting to show signs it is running to difficulties)
      • operating expenses (are there big jump or corresponding decreases when the company scale down operations especially during a recession)
    • cash flow statement
      • net working capital (is there a big decrease- there could be cash flow problems later, or if a big increase- the company could put it to better use to expand operations else give it back as dividends)

When you have done all of that, it is just the bare minimum, as you  journey on the road  towards financial freedom. Later, you will be looking at long term liabilities, the company's accounting policies, amount of short term debt, risk management, any changes in accounting policies, potential lawsuits mentioned in reports etc.

I hope that this series has given you something to think about when you next buy a stock. I've not covered everything I wanted to, but it should help you understand what to look out for when you buy a stock.

We'd look at how Earning Per Share (EPS) affects the share price of a company in the next series on Wednesday.

Other posts in this series:

1. How to Select a Stock to Keep? Part 1 of 3

2. How to Select a Stock to Keep? Part 2 of 3 


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