Should I buy stock in company X? Part 1

Tuesday, June 24, 2008

Today on a message board a question was asked about which stock to buy, Pfizer (PFE) or Abbots (ABT). I responded by telling the user not which stock to buy, but what information he needed to know about both companies before making a decision.

First, before we get into determining if a company's stock is a good investment or not, we must understand the basics of business. This may be repetitive for some, but I don't want to assume everyone knows what I'm talking about. To aid this example, I'm going to use an individual's finances to explain these concepts.

Liz is a Manager at a bookstore and she earns $24K per year and owns her own home. Liz has a car and a couple of credit cards. As a home owner, Liz pays property taxes, home owners insurance, gas, electric, cable, and water bills. Liz takes her lunch on most days and eats out a couple times of month. She goes to the movies about once a month and she likes to shop for clothes. These are Liz's monthly expenses.

Her monthly income is $2,000 and we'll estimate her expenses at $1500 per month. Liz has $500 left over at the end of each month. Since she has money left over after paying all her expenses, Liz is cash flow positive. Cash flow is the amount of money left after all expenses are paid within a specific time frame. If the number is positive (meaning greater than zero) then the cash flow is positive, if the number is negative, then there is negative cash flow. If Liz expenses for the month had been $2100, then she would have had a negative cash flow ($2000 sales - $2100 expenses = -$100).

If Liz was a company, would she make a good investment? What's are Liz's sales (how much money does she earn)? Has Liz earned a profit? Say for the past twelve months, Liz is cash flow positive each month by $500 and she would be profitable by $6000 for the year (12 months X $500). Liz made more money than she paid out, so her gross profit (income before taxes and other expenses) is $6000. We'll assume Liz is taxed at 10% ($24000 X .10 = $2400) on her sales (income). So her gross profit is $6000, however, after paying taxes her net income is $3600 ($6000 - $2400). Think of net income as take home pay, excluding deductions.

In the next few posts, I'll continue to develop this example. Hopefully, at the end of this series, you will have a basic understanding of how to analyze a company's business.

Terms:

Cash Flow - the difference in the amount of money received versus what has been paid out in a specific time frame. Or said another way, sales (revenues) minus expenses for the last 3 months.

Gross Profit - is sales minus expenses (not including taxes and other non-operating expenses).

Net Income
- is sales minus all expenses (including taxes and other items). If this dollar amount is less than zero, then this is referred to as a Net Loss.

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