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New to investing? The one thing you need to know before buying stocks

Many people think they just need to know a brand to be able to invest in its stock. But do they? Or is there so much more to investing decisions that brand-awareness?

You wouldn’t buy a house without checking the infrastructure, or a car before kicking the tyres, would you? But people don’t think twice about piling into a stock because an anonymous person on a bulletin board told them it would multi-bag.

Crazy! I know, right? But even if people do a bit of research, the chances are they’ll spend several hours more trying to save £50 on an American style fridge-freezer than they do picking investments with their own hard earned cash.

What’s the market cap?

So, let’s look at a few things investors need to know. First, the market cap. This is the value of the total equity. If you don’t know that, how can you know if the stock is good value? Many people make the mistake of thinking that the share price matters most — it doesn’t. We can calculate the market cap by taking the outstanding number of shares in issue and then multiplying this by the share price.

For example, if a stock has 1,000,000 shares in issue and the share price is 100p – then the total equity value of the company is £1m.

So, is a company that is worth £2m more desirable than a company that is worth £1m? Not necessarily. What if the former company has £10m in net debt and the latter £1m in net cash? Now which company would you rather own? Obviously, the latter is way more attractive.

Check the balance sheet

The next step is to check the balance sheet. We want to check the company’s ‘cash at bank’ and its net debt. This will give us its enterprise value, or EV, which is the true price we would pay if we bought the business.

We can calculate this by taking the market cap, or the equity value, and adding the debt, and subtracting the cash. Remember, if we buy a company, we take on the debt! That’s why when many companies go bust they are sold for nominal sums, which seem tiny, like a single British pound. But the buyer also assumes all of the debt the company has — which can run into the millions.

Check the cash flow statements 

Many people think the income statement is more important. But cash is key for any business. A company can make a lot of profit, but it those profits are not being converted into cash, there’s a problem.

Let’s say a company makes £10m in profit a year, but is having to depreciate by £20m every year the machinery it owns over a period of five years (its useful life). Depreciation is not a cash expense, but the machinery will need replacing every five years for £100m, and the business is only making £10m profit a year! Clearly, cash matters. 

Always check the cash flow statements for cash generated in operations, but also the cash flow for investing. Understanding how cash moves through the business is the best skill any investor can have. Companies such as BP have done well because it has managed its cash flows. 

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Michael Taylor has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.