Five questions to ask yourself before buying stocks
If you’re like most people today, you’ve either thought about investing in the stock market or you’ve actually gone out and bought a few stocks. If that’s fine, there’s a lot of money to be made in the stock market, but the important question is; How do you choose your stocks?
- Did you buy stock, because your brother told you to?
- Did you get a hot tip from your postman?
- Or are you just buying stock because you like the company’s products?
Believe it or not, most people who invest in the stock market invest their hard earned money based on the above examples without further research.
Does this sound like a smart way to invest in you? This is of course not for me.
Now if you’re asking your brother what stocks to buy and your brother happens to be Warren Buffett, then I think it’s safe to say you’d make a good investment, but how many of us can claim Warren Buffett to be our brother?
For most of us this kind of investment is very risky, while you can make money, it is more likely that you will lose money.
To help you guard against losing your money and to help you make the best choices when choosing stocks, below you’ll find the five most important questions to ask yourself before buying stocks.
1. What Does the Company Do?
This sounds like pretty basic information, but it can be difficult to find. Most companies offer more than one product; Large conglomerates may offer hundreds of different products in a variety of industries. Digging into the ranks of the company can give you a better sense of the power that will drive the results.
Examining the cans of the company’s product line also tells you where the profits are coming from. For example: video games accounted for 11% of Sony’s total SNE sales in 2000 but 40% of its revenue.
Annual reports are the best source for this kind of information. Be sure to read shareholder letters, as well as presentations on the company’s product lines. It is also part of the company’s SEC filings.
2. How Fast Is The Company Growing
Over a long period of time, share prices have been driven by revenue growth. It can come when the company cuts costs, but in the end, revenue must increase if income is to continue to rise. If revenue, also called sales, is increasing, that’s a good indication that something is working. Perhaps the company boasts a better than average product or a more effective sales force. Conversely, marking a sale can signal trouble.
Revenue growth indicates that the company is making more than enough to offset its costs. An established company must show consistent results, but young firms often display strong revenue growth with little or no income. Watch a myriad of Internet companies with lots of sales and no profits.
3. How Profitable Is It?
As well as growth, look at how efficiently the company makes money. The return on assets shows how well it has translated one dollar from its asset base into one dollar of profit. A company with a 20% return on assets, for example, has generated $ 0.20 in revenue from each dollar of assets. Likewise, return on equity measures how well the company has turned shareholder equity dollars into income.
Measures such as return on equity and return on assets help you understand how efficiently a company is allocating its resources, and they allow you to look beyond raw profit figures. Companies with the same income figures may have very different returns on equity and returns on assets, depending on how well they have turned their assets into profit.
4. How Healthy Is Financially?
Income and cash flow are two different things. You can get a very generous salary but still have cash flow problems if you are paid only twice a year. Because of the peculiarities of accounting practice, the income a company reports often differs from the amount of cash it carries at the door. The cash flow statement, which is part of the annual report, will tell you how much money the company has pocketed.
There are no hard and fast rules that will tell you how much debt a particular company should pay, as debt levels can vary across industries. To get an idea of whether a company is burdened by debt, divide its assets by its equity. The result is leverage
5. Is It Worth the Value?
A company might clear all of these hurdles, but sell for too high to be an attractive investment. It all depends on how much the prospect is worth.
To find out, look at the future Price / earnings ratio, for example General Electric has a forward P / E of 41, which means that shareholders are now paying $ 41 for $ 1 of the company’s future earnings.
Another widely used measure is the price / book ratio. It shows how many shareholders paid $ 1 of the company’s assets.