The best advice I’ve ever heard regarding investing is if you don’t understand the investment don’t put your money into it. Similar advice can be said about stocks and is the philosophy of some of the greatest money managers. If you don’t understand how the company makes money, don’t buy the stock. It’s a pretty simple idea, but often overlooked.
By knowing how a company makes money, it becomes much easier to understand what will help and hurt a company when the facts change. Higher oil prices, for instance, may be good for an oil company, but bad for transportation companies.
If we are researching McDonald’s Corp. (NYSE: MCD), the next step is to find out how the company makes money. Head on over to your favorite research site and look for the company profile section. Digging through this information is the best place to start your research.
Know The Sector
There are several sectors that make up the economy. Each sector contains businesses that have the same or similar products or services. A stock will always fall into one of these sectors: Basic Materials, Industrial Goods, Consumer Goods, Financials, Healthcare, Services, Technology, Utilities, and Energy.
The reason a company’s sector matters is for diversification. It’s best to have no more than 20% of your portfolio in any one sector. You don’t need to be invested in every sector, but having a diversified portfolio across several sectors is a good idea.
For our example, McDonald’s fits into the Services sector. Which tell us that it sits in one of the broadest sectors of the economy. This gives you a good point of reference later on if the stock turns out to be investment worthy. Owning one or two stocks in the same sector can work out in your favor if they fit into separate industries.
Know The Industry
Just like the economy can be broken down into individual sectors. Each sector has several industries. An industry is a group of businesses that have similar business activities. Companies in the same industry tend to grow and make money in a similar way. Because of this it’s very easy to compare companies in the same industry.
From a diversification standpoint, you ultimately want to avoid owning more than one stock in the same industry. Stocks in the same industry tend to move in tandem with each other. However, if you choose to own more than one stock in the same industry, you take a bigger risk with your investment by doing so.
If we look again at McDonald’s, it fits into the Restaurant industry. If you didn’t know already, McDonald’s sells food, which is a very basic idea how the company makes money. By looking into the business summary we’ll get a better idea how the business works.
The Business Summary
Looking at the business summary for McDonald’s tells us the company is a food service retailer that offers various food items, soft drinks, coffee’s, and other beverages. At the end of 2010, there were just over 32,000 restaurants, in 117 different countries, including 26,000 operated by franchisees and 6,000 company owned.
To keep it simple, McDonald’s takes raw uncooked food, processes it, cooks it and sells it you and me for a profit. A large portion of the money being made is through franchisees, which pay licensing fees and royalties monthly. By having such a large franchisee base, McDonald’s shares the business risk with individual owners but still makes money in the process. When you buy your next Happy Meal, there’s a good chance that McDonald’s will only see a small portion of what you paid for it.
Understanding how a company makes money, gives you a better chance of making money for yourself. If you aren’t sure, or don’t understand, just avoid that stock and move on to the next one. McDonald’s may have been an easy example being a restaurant. But what if the stock was an oil or tech company. Do you know how Google makes money? What about Exxon Mobil?