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To this point, "we've investigated the financial performance of companies. We've assessed their competitive strengths by investigating their economic moats, and we've analyzed their financial statements.

In Chapter 7, I'll discuss how to assess the quality of management. In Chapter 8, I'll give you some tips on how to spot aggressive accounting, after which we'll turn to perhaps the toughest task faced by any serious investor: Deciding on a fair price for the stock. How can we avoid paying too much for excellent companies, while not being so cheap that we let wonderful opportunities pass us by? In Chapters 9 and 10, I'll show you how to value stocks.

Investor's Checklist: Analyzing a Company — The Basics

•  When you're evaluating a company's growth rate, don't get swept away by
heady historical growth. Make sure you understand where the growth is
coming from and how it can be sustained over time.

•  Be wary of companies that have relied on acquisitions to boost growth.
Most acquisitions fail to produce positive returns for shareholders of the acquiring firm, and they make it tough to evaluate a company's true growth rate.

If earnings growth outstrips sales growth over a long period, this might be a sign of manufactured growth. Make sure to dig into the numbers to see how the company keeps squeezing out more profits from stagnant sales. Return on assets measures the amount of profits that a company is able to generate per dollar of assets. Companies with high ROAs are better at translating assets into profits.

ROE is a good measure of profitability because it measures how the company is at earning a return on shareholders' money. But because companies can boost their ROEs by taking on more debt, don't take it as gospel. For a nonflnancial company, look for an ROE of at least 10 percent, without excessive leverage.

Free cash flow gives financial flexibility because the firm isn't relying on the capital markets to fund its expansion. Firms with negative free cash flow have to take out loans or sell additional shares to keep things going, and that can become a risky proposition if the market becomes unsettled at a critical time for the company.

Be wary of companies with too much financial leverage. Because debt is a fixed cost, it magnifies earnings volatility and leads to more risk. Before you buy a stock, think through all the potential negatives. This can help you make better decisions if bad news does come down the pike.

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