Stock Research Strategy

An earnings statement tells you how well -- or poorly -- the company performs.

We've all had that special friend that raves to us about a hot stock tip. But picking stocks based on a whim can backfire if you don't perform your own due diligence. Think of stock research as conducting an interview with a company before you invest your money in it. Your investor style will determine how much weight you give to capitalization, performance and growth. And take a cue from Warren Buffett, the most famous investor in the world: Never invest in a company you don't understand.

Market Sector Comparison

Use the same type of data to compare companies.

Suppose you're researching a company that creates and sells computer software. This places it squarely in the technology sector -- with lots of competition. A quick peek at Morningstar's stock sector reports tells you that as of March 2011, this sector had five-year returns of nearly 10.5 percent. Now you can compare companies of similar size, performance and revenue to get a representative sample. Stay in the same sector. For instance, don't compare your technology stock with Krispy Kreme, the doughnut maker. When reviewing company data, look at five years' worth of summaries to get an idea of how the sector has performed and how your stock might fare.

The Earnings Statement

Yes, it's in the numbers. Deciphering a company's earnings statement isn't as scary as the terms "cash flow," "income statement," "earnings per share," and "balance sheet" might seem. But you do need a rudimentary understanding of accounting to make sense of the information. Every publicly traded company must file a quarterly report, known as the 10-Q, and the annual report, the 10-K, with the Securities Exchange Commission. You can read these online at the SEC website, the company's site or websites that pool this data. The Seeking Alpha website lists hundreds of transcripts of earnings calls indexed by company.

How Much is it Worth?

Let's compare the share price of two imaginary companies in the durable goods sector. Stock A has a price of $36.87 while stock B is $39.20. Stock B is worth more, right? Well, it costs more, but cost is different from worth and value. You want to compare the price-earnings ratio of each company. This ratio tells you how much it costs investors per dollar of the company's total earnings to own the stock. It's commonly used as a measurement of a company's growth. Compare price-earnings ratios across companies in the same sector to learn what's considered an acceptable range and whether you have an overpriced or undervalued stock on your hands.

Dig into the Background

The financial data tell one side of the story but to get a complete picture you need to dig a little more into the company's profile. An unstable or inexperienced management team could become a handicap to the company. Borrowing like crazy and being mired in debt signals a potential liability. Have they earned a reputation in the marketplace -- good, bad or indifferent? Keep a file on a company you're researching and add news stories, press releases, changes in management and other news affecting the sector.

References

• Morningstar: Stock Sectors
• "The Economist Guide to Analysing Companies"; Bob Vause; 2009
• Securities and Exchange Commission: Beginners' Guide to Financial Statements
• Financial Industry Regulatory Authority: Stocks

Resources

• Securities and Exchange Commission: Company Search
• Seeking Alpha: Earnings Call Transcripts