When Picking Stocks, Derivatives Matter

Even if you shy away from derivatives for your own portfolio, there's a good chance they might still affect your stock gains this year. You may not know it, but derivatives can lead to some potentially big effects on the financials of companies that invest in them -- something worth knowing if you're thinking about plopping down some cash on a stock. Here's a rundown on investing in companies that use derivatives.

Those Darned Derivatives

By now you've heard plenty about using derivatives as an investment choice, but what if one of the companies you're thinking about investing in uses them too? It's a scenario most investors -- and even some analysts -- probably don't even consider.

But I'll admit I'm a little partial. I've got accounting on the brain. I've been spending the last couple of weeks on the financial audit of "a Fortune 500 energy company," and as you might expect, they use lots of derivatives in their day-to-day business.

And that's the case with lots of other kinds of companies, too. Everyone from Southwest Airlines ( LUV) to Allegheny Energy ( AYE) use derivatives (like futures and forwards) to hedge against commodity prices, multinationals use derivatives to limit their exposure to foreign currencies, and financial services companies use derivatives for all sorts of applications.

That all sounds really savvy, but as long as the share price keeps climbing, who cares if companies use derivatives, right? Wrong.

Since U.S.-based companies use "generally accepted accounting principles" ( GAAP) when they deliver their financial statements to investors, it's important to think about some of GAAP's quirks when you're valuing a company to make sure you find any hidden value or "value traps."

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