Ask questions before you invest in a company

A seemingly solid and promising company isn’t always a great investment. Before plunking your hard-earned money into any company, do some homework. Below are some questions you should ask about any potential investment. (Don’t get intimidated or discouraged by them. You needn’t master everything at once. Beginning investors should just keep learning slowly. We can help you at www.fool.com/school and you can learn a lot from Motley Fool books and those by Peter Lynch, too.)

•What business is the company in? What’s its business model (that is, how exactly does it make its money)? Is it in a profitable, growing industry?

•What’s the company’s track record? Have revenues and earnings and profit margins been increasing in past years? How do these numbers compare with those of competitors?

•What’s discernible from its financial statements? Has the company’s debt level been rising or falling? Are accounts receivable and inventories rising no faster than revenues? Are profit margins healthy and, ideally, growing? How about return on equity (ROE), return on assets (ROA) and other measures? Are there any red flags to worry about and investigate further? Is anything in the statements unusually cryptic? (Enron’s statements were cryptic — it’s good to avoid what you don’t understand.)

•What’s the company’s competitive position and strategic vision? Does it have a strong brand? Does it invest sufficiently in research and development of new products and/or services? Is it a leader in its field? Is it gaining market share? Do you have confidence in management — and its ability and dedication to keep the company growing, to be frank with stakeholders, and to look out for shareholders’ interests?

•What risks do the company and its investors face?

•Is the stock valued attractively? This is a difficult question to answer for any stock, and there’s usually no single right answer, either. You might begin by looking at the company’s current P/E ratio, comparing it to its historical levels. If the P/E is 35 and it’s usually been in the 20s, the stock might be overvalued.

Ask the Fool

Q: Should I try my hand at investing in commodities? — K.W., Walnut Creek, Calif.

A: Commodities are very risky. Global commodity exchanges facilitate trading in all kinds of things, such as interest rates, currencies, metals, crude oil, gasoline, cotton, lumber, sugar, coffee, wheat and corn. According to The Wall Street Journal, “Investing in commodities and financial futures is about as extreme as you can get on the risk scale.”

Investors are drawn to commodities because of the great leverage available. You can often buy items by paying only about 10 percent of their value. In an extreme example, if you buy $50,000 of pork bellies for $5,000 and they double in value, you’ve made a lot of money by investing just a little. Of course, if they fall in value, you can lose your entire invested amount — and then some! You can lose much more than you invest with commodities and futures. Smart people have lost a lot of money in them, and most investors should steer clear.

My smartest investment

I’ve fallen for various penny stocks in the past, even when I should have known better. There was often “pumping and dumping” going on, where hypers (sometimes even the management) run the share price up, then sell and leave lowly shareholders holding the bag through an implosion. I now take my late father’s advice. He was a cattle rancher who said to buy shares of Caterpillar. It’s well-managed, and if you look at the state of America’s infrastructure, it should have a market for years. My only regret is that I didn’t put a lot more than $1,000 into it, since it has more than tripled in value since 2000.

— G.S., Kit Carson, Colo.

The Fool Responds: Dad was right. Big, established companies, such as Wal-Mart and Procter & Gamble, can deliver solid growth for years.