Do your homework before buying stocks.
When you decide to try your hand at stock picking, it’s essential to do your homework. Your goal is to find a good value – especially if you plan to hold on to an asset for a while. But before you put full faith in a company, you should do thorough research, reviewing a stock’s fundamentals to monitor its viability and checking if it still has room in your portfolio. This isn’t a simple stock purchase – you are becoming a shareholder of a company, so investors must be willing to do the proper analysis. Here are seven things you should know about a company before investing your hard-earned cash.
Trends in earnings growth.
Look for trends in a company’s earnings growth. Over time, do the earnings generally increase? If so, it’s a pretty good indication that the company is doing something right. Even small, regular improvement over a long period can be a positive indicator. But earnings growth and value have to go hand in hand in order for the stock to be worth the investment. “Evaluating a company is a combination of understanding how the business works and how valuable its future cash flows are,” says Faron Daugs, founder and CEO of Harrison Wallace Financial Group in Libertyville, Illinois. “This involves evaluating its products/services, target market and cost structure. This process allows one to determine a company’s competitive advantages, market opportunity and the sustainability of cash flows.”
Company strength relative to its peers.
Start by looking at an industry represented in the market and establish if there is future growth potential. Industry can be a great screener when investing. However, when picking individual stocks in an industry, you need to look at where the company fits in. How does it fare against its competitors? Is there an advantage that allows it to stand out? These critical questions can help determine if a company has an edge. When comparing a prospective company to its peers, says Greg McBride, chief financial analyst at Bankrate.com, “Evaluate the growth of sales and earnings and check the statement of cash flows to make sure that those sales are translating into actual cash earnings for the business.” To make a fair comparison, line up competitors of the same size or market capitalization and review their performance during the same time period.
Debt-to-equity ratio in line with industry norms.
All companies carry debt – even Amazon.com (AMZN) and Apple (AAPL). Investors can use debt as an indicator of the company’s financial well-being. Watch out for companies with high-debt levels relative to their equity, or its debt-to-equity ratio. To find this number, divide the total liabilities on the company balance sheet by the total amount of shareholder equity. For those with a lower risk tolerance, that number should be 0.3 or less. There are exceptions. For example, look at the debt-equity ratio across an industry. In the construction industry, with its reliance on debt funding, a higher ratio might be acceptable. Make sure your pick is in line with industry norms.
Price-earnings ratio can help provide market value.
The P/E ratio is a valuation metric that measures how well a stock’s price is doing relative to the company’s earnings. When using fundamental analysis and value investing strategies, P/E ratio is considered a major indicator of whether a stock is undervalued or overvalued. It gives insight into a stock’s market value, or its worth according to financial markets. To find the P/E ratio, divide the company’s share price by its earnings per share. If a company is trading at $40 per share and the earnings per share are $2.50, the P/E ratio is 16. P/E ratio can be helpful to compare companies in the same industry or sector.
How is a company treating its dividends?
A company that pays dividends is often one with a degree of stability – especially if the company has increased its payout consistently each year for decades. Watch out for companies that have very high yields, though. A spike in dividend yield can mean a company is getting desperate. High dividends could also be an indication that a company isn’t investing enough in itself. A company can temporarily or permanently cut its dividend to secure more liquidity during challenging economic times. This doesn’t necessarily mean the company is in jeopardy, but rather the business may require more cash to pay immediate expenses and investors shouldn’t be worried initially, experts say. “Sometimes the company or industry reduces or eliminates the dividend because it’s in permanent decline and is an indication of worse to come, but other times it can be that they’re in temporary difficulty,” McBride says. “Evaluate the long-term merits of the company and its industry to see if they can resume paying dividends in the future.”
Effectiveness of executive leadership.
How much do you trust the people at the top of a company? Effective leadership promotes a stable and long-lasting company culture with innovation and flexibility at its forefront. Companies that invest back in themselves develop their business growth and increase their footing in their industry. A well-managed company is often one that enjoys stock prices that trend higher. To evaluate the effectiveness of a company, John Cunnison, vice president and chief investment officer at Baker Boyer Bank in Walla Walla, Washington, says, “Strong company-level analysis requires that investors have an understanding of the range of possible futures (in) both qualitative factors (company culture, employee and customer satisfaction, brand recognition and loyalty) and quantitative factors (revenue growth, profitability, cash flow, debt levels).” Through these details, investors can make observations about a company’s prospects and the direction management is taking, all valuable insights in your stock-picking decisions.
Long-term strength and stability
The nature of the stock market – at least day to day and year to year – is volatile. At some point, a company is going to lose value in the markets. But what really matters is long-term stability. In general, trend lines smooth out and head higher. Look for that with individual companies as well. A company that weathers the downturns and comes back relatively strong, and that only seems to have real trouble when everyone else does is probably a good bet. Ultimately, a stable company exhibits strong characteristics of the items on this list: grows revenues, maintains low debt levels, is competitively positioned in its industry and has effective leadership. These are just some of many important components of stock-picking. If one of these variables changes, investors should take note and determine if it’s a buy or a bust.
Here are seven things an investor should consider when picking stocks:
- Trends in earnings growth.
- Company strength relative to its peers.
- Debt-to-equity ratio in line with industry norms.
- Price-earnings ratio can help provide market value.
- How is a company treating its dividends?
- Effectivness of executive leadership.
- Long-term strength and stability.