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The Motley Fool

Ask the Fool

Due Diligence

Q: If I’m drawn to a young and growing company, what should I look into before investing in it? — T.S., Bradenton, Florida

A: First, make sure the company has competitive advantages. These might include a strong brand, a solid reputation, valuable patents or economies of scale.

Check out the financial statements it has filed with the Securities and Exchange Commission (SEC.gov/edgar.shtml). Its income statement should feature growing sales (sometimes called revenue) and income. On its balance sheet, figures for inventory or accounts receivable should not be growing faster than sales. Heavy or quickly growing debt are additional red flags.

Look at the company’s statement of cash flows to see how it’s generating cash. Ideally, most cash should come from ongoing operations — the making and selling of products or services — and not from issuing debt or stock or selling property.

Examine the company’s profit margins (gross, operating and net). Higher margins suggest that it has a strong brand or special technology it can charge more for. Ideally, profit margins should be growing over time — or at least not shrinking.

Finally, assess how attractive the price is; while a company may be terrific and promising, you don’t want to overpay for its shares. Comparing its price-to-earnings (P/E) ratio or price-to-sales ratio to its five-year average — which you can find at Morningstar.com — will give you a sense of how its valuation has been changing over time. (Enter the company’s ticker symbol and then click on the “Valuation” tab.)

You can learn much more about how to evaluate companies at Fool.com .

Q: How can I access my credit report? — F.R., Riverside, California

A: Visit AnnualCreditReport.com, where you can get free copies annually.

Fool’s School

‘The Dow’ Is Not What You Think It Is

When you hear of “the Dow” in the news, you might think the term refers to the entire stock market. It doesn’t — and the Dow is surprising in other ways, too.

The Dow is an index of a tiny subset of the United States stock market, comprising just 30 companies. Its full name is the Dow Jones Industrial Average, and it was launched in 1896 with just 12 stocks, which included now-obscure names such as U.S. Leather and National Lead. (General Electric is the original member you’d most likely know, but it departed the index last year.) Current companies include Apple, Caterpillar, Coca-Cola, Home Depot, IBM, Johnson & Johnson, McDonald’s, Nike, Verizon Communications, Visa, Walmart and Walt Disney.

For an index that better reflects the overall market, consider the S&P 500, which contains 500 of America’s biggest companies, which together make up about 80 percent of the overall market’s value. (The Dow makes up 25 to 30 percent of the market value of the S&P 500.) You can go even broader with the Dow Jones U.S. Total Stock Market Index.

Another problem is that the Dow is “price-weighted,” with its components that have high stock prices (such as Boeing, recently trading near $380 per share) more strongly influencing the index’s value than those with low prices (such as Pfizer, recently near $42). With price-weighting, Boeing would be around 9 times more influential than Pfizer, though both have market values in the $200 billion range. The S&P 500 index, in contrast, is a market cap-weighted index, with the biggest companies (measured by market value) having the most influence.

It’s good to understand what the Dow is and its place in American financial history. But if you want a good sense of how the overall market is doing, look at the S&P 500 or a total stock market index instead. Also, don’t get excited by headlines in the media such as “Dow plunges 200 points!” With the Dow recently near 26,000, 200 points is a move of less than 1 percent. Focus on percentages, not points.

My Dumbest

Investment

Win Some, Lose More

In 1966, just out of college, I bought 15 shares of a stock at $9.75 apiece (total investment: $146.25, less the trading commission). About three years later, I sold them at $127 per share for almost $2,000! When the stock fell back to $10 and was paying a $1 dividend, I remembered my positive experience and bought 1,000 shares. Soon thereafter, though, the company suspended its dividend and promptly fell to around $4, erasing much more than the phenomenal gain I’d made in my first three years of owning it.

Lesson learned: If you sell it, you sell it for a reason. If it falls a lot, it does so for a reason. Don’t get so enthralled with a stock that you don’t do your research and fail to be objective. — J.M., Tampa, Florida

The Fool responds: That’s a terrific initial gain, though clearly, buying into the stock again was a mistake.

You’re right that you needed to do your homework. One might assume that a stock that soared will keep soaring, but it doesn’t work that way. A stock that has surged more than 1,000 percent in three years may well be overvalued and likely to pull back at least a little for a while.

It’s important to have a good grasp of a company’s health, performance and risks — and to keep up with its progress — if you’re going to invest your hard-earned dollars in it.

EDITOR’S NOTE: The Motley Fool is an investment column created by brothers David and Tom Gardner and distributed by Andrews McMeel Syndication.

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