June 20th, 2019

How To Take The Guesswork Out Of Picking A Stock (2 Of 6)

This morning I noticed something not that unusual as I was standing at Starbucks waiting for my breakfast egg white omelet. The man standing next to me had the Robinhood app open on his phone and was scrolling through a list of stocks he was interested in following (Sound familiar?).

Since I am a proponent of Robinhood for Smart Money Math, I leaned over and asked him how he liked the app. Unsurprisingly he told me he liked it especially since it allowed him to quickly choose which stocks he should buy and which he should sell.

Curiously I asked him what specifically within the application made this choice so easy. His response: The trend of the price on each equity listed side-by-side. Insert forehead-to-hand here.

I know this is the way many people choose stocks. It’s called technical investing which can work but can also fail since it’s really not based on anything fundamental about the underlying company itself.

True, there is information to be gleaned from the price trajectory of a stock ONCE YOU UNDERSTAND THE FUNDAMENTALS...

Instead of spending thirty minutes a day following the price trends of dozens of stocks, I suggest you use that time to read something very important about one of those stocks. What am I talking about?

The Balance Sheet

As I explained in my previous post, the balance sheet can be found for any US company using the Edgar Database provided for free by the SEC. SO why would something like this be useful?

Well, the balance sheet of a company represents the snapshot of the financial health of a company. It tells you how much money it has in the bank, how much money it is owed by customers and how much debt it has (both current and long term). I’ll explain all the details below, but first take a look at the balance sheet for Apple shown below... or better yet pull it up yourself.

Source: SEC

Right off the bat the you may notice two main headers within the table: Assets and Liabilities and Shareholder Equities. The first section of the table (Assets) tells you all the good things the company has in its financial snapshot. Unfortunately, each company has slightly different names of the rows under the assets title, but the most important are explained below.

Asset Terms

  • Cash and Cash Equivalents – This is the cash the company has on hand at the current moment in time
  • Marketable Securities – This could be stocks, bond or some other financial instrument the company owns
  • Accounts Receivable – These are the IOU’s that the company is waiting to get paid for from customers or others
  • Inventories – This the current amount of product the company has on hand
  • Property, Plant and Equipment – This represents the current value of the buildings, stores and other equipment the company owns

You may wonder what the difference between “current assets” and “non-current assets” entails. Current assets are things the company expects to convert to cash within one year from the report date. Non-current assets represent long-term investments for the company where the full value of the investment might not be realized within the current year.

Below the Assets header are the Liabilities and Shareholder Equities. Within this section some of the key rows include the following.

Liability and Shareholders’ Equity Terms

  • Accounts Payable – This is all the outstanding payments owed by the company to suppliers
  • Deferred Revenue – This represents money the company has collected but still needs to deliver the product the customer
  • Retained Earnings – This is the amount of net income the company has left over after it has paid out dividends to shareholders
  • Total Shareholder’s Equity – This represents the value of the company’s total assets minus its total liabilities. You can actually check this value by using the reported values above in the balance sheet.

Now compare that to the balance sheet for Game Stop.

Source: SEC

The one new row I want to point out is “goodwill” in the assets section. This represents money the company paid above and beyond the fair purchase price to acquire another organization. Generally, I am not a fan of goodwill especially since it’s intangible and is just an accounting trick to show the company overpaid.

So, what should you be looking for in these numbers? Well different business models will generate different looking balance sheets so that is really a tough thing to answer. However, there are few things I look at for every company I review.

  • What is the trend in total assets and total liabilities? Are they going up or down?
  • How much cash does the company have on hand? Are current assets greater than the current liabilities?
  • Are there any interesting items like goodwill in the table?
  • What is the total amount of stockholders’ equity? Is that going up or down?

If you use these questions as a guide you will see from the example above that the balance sheet for Apple appears much stronger than the balance sheet for Game Stop. This shouldn’t necessarily cause us to take action (yet), but it is one data point we need to consider when making the decision to buy or sell a given stock.