A stock (or a share) is something a company sells to the public during an initial public offering (IPO). Selling shares to the public is a way for a company to get additional capital to fund projects or expand its operations. When you, an investor, buy shares, you own a stake in the company and can vote on major decisions like who the board members should be, or if a merger should happen.
Stock picking can be daunting. However, if you know what to look for in companies and the stock market, the decision-making process becomes easier. This article touches on 6 things to look for before buying a stock.
Earnings
A company’s earnings signal its profitability. Earnings are the after-tax profit a company makes. Analysts estimate earnings for companies and good estimates mean the analysts think the companies did well at that point in time.
You can find the earnings figures in the income statement section of the financial statements. Earning estimates can be found in analysts’ recommendations from research companies.
The share price is tied to the profitability of the business. Profitability is tied to the lucrative projects and innovative ideas a business has. The better the innovations, the better the stock price performance. I mean, look at Tesla.
Doing an analysis of a company’s past earnings and projected future earnings, as well as their current and future ideas/projects, is a good starting point to pick a good stock.
Management
Good earnings can boost a stock price. The type of management and their style of leading also determines the direction of a stock price.
Answer this question: who would you lend money to? A colleague-turned-friend who needs money to help his parents? Or that one aunt who never really talks to you but now wants you to lend her money.
The answer to that question depends on one thing: trust. You will lend money to the person you trust more. This works the same with the management of companies; if you lose your trust in them, you will pull out your investments. Looking at who the managers are, their experiences, failures, successes, and even their character will help you determine if a company’s stock is a good buy or not.
The CEO of Gravity Payment, Dan Price, increased the minimum wage of his workers to $70,000 annually. While some critics said this would lead to bankruptcy, the company is actually thriving. This is a good example of management investing in their employees and their investment paying off.
Good management translates to good company performance. Invest in the right management.
Industry and Competitors
The point of investing is to make more money. There are pockets of wealth in different industries. Before you pick a stock, do research into the industry you want to invest in.
During the pandemic, when lockdowns started worldwide, if you were lucky to still have had your job, you most likely would have seen an increase in your discretionary income due to the fact that transportation and entertainment costs would have decreased. Imagine you were looking for somewhere to invest this surplus income amidst the pandemic. If you stumbled upon a company in the energy industry, after doing some research, you would have come to a conclusion that because flights were grounded and no one was driving, no one used petrol/fuel much. This would have hurt the oil companies like BP. Investing in them would have seen your investment go down.
On the other hand, if you saw just how much money was spent to fight COVID, you would have concluded that investing in the healthcare industry would have been more lucrative than the energy industry, all else being equal.
After picking the industry, looking at the different companies within that industry is the next step. This is part of top-down investing. Looking at metrics such as earnings per share, debt to equity, dividend yields, price/earnings ratio, etc, can help you determine which company within that industry is undervalued or overvalued. If a company has better metrics and a better competitive advantage than its peers, then its stock is worth considering adding to your portfolio.
Finding what industry is poised for long-term growth will help you determine which company within that industry you want to go for.
Debt
Debt is leverage and can magnify your gains. It can also magnify your losses. Paying attention to a company’s debt to equity ratio is an important way to assess its debt burden.
A “good” debt to equity ratio varies from industry to industry. One simple way to find out if a company’s debt to equity ratio is normal is to find its industry average debt to equity ratio and compare it with the company’s own debt to equity.
High amounts of debt can be catastrophic for a company. If at any point the company defaults on paying its debt (both interest payments and principal), it will drastically affect the share price and your investment.
You can also look at a company’s cash flows in relation to its interest expense.
Here is an example using John’s Icecream Parlor:
John has $5000 saved from working odd jobs. He has done his market research and has decided that an ice cream parlor would be a lucrative business. In order to start, he needs $15,000. He goes to the bank and gets a loan for $12,000. In total, he has $5000 equity plus a $12,000 loan. His debt to equity is $12,000/$5000 = 2.4.
The debt to equity ratio shows that he has 2.4 times more debt than equity. If the interest on the loan is $300 per month, and his business generates profits of $2000 per month, then his business is doing really well and the loan is working for him. In this case, an investor might see that despite the loan being high as compared to his equity, his cashflows are more than enough to cover the interest expense. This is a good thing.
If, on the other hand, his profit was $500 per month, this might be a cause for concern and it signals financial trouble. You want the company’s cash flows to more than cover the interest expense. Think of it like this: if you get your salary and the bulk of it goes towards paying your debt interest, you would have little to survive. This analogy applies to companies too. You want their cashflows to be enough so that if emergencies happen, they can cater for it and not borrow more.
Paying attention to the debt of a company and its capacity to pay back its debts is critical when looking to buy its stock.
Volatility
Volatility is the up and down movements of a stock price over time. The more frequent and the bigger the dispersion in stock price, the higher the volatility.
Volatility is not all bad. Volatility helps with dollar-cost averaging in the long run. However, if a stock is too volatile, it can affect your portfolio performance. One minute it’s up, the next minute, your gains have been wiped. Think of it as mood swings. You want fewer mood swings.
Look at the past performance of the stock to assess the volatility and also see the trend – is it volatile but has an upward trend? Downward trend? Flat? Remember, the point is to make more money. So avoid taking unnecessary risks wherever possible.
Dividends
Dividends are income gained from holding stock. If the stock is a cow, dividends are milk. You can either drink (spend) the milk or save and sell (reinvest) the milk to buy another cow.
For example, if in the first year of holding a stock, it paid you a $0.10 dividend per share, and you own 10,000 shares, then that means you got $1,000 that year. If in the second year, it paid a dividend of $0.08 per share, then you got $800; and so on and so forth.
If you are someone who wants income, then look for a good dividend-paying stock. Look at the company’s dividend payment history to see how stable the payments have been.
Dividends are also a good signal of cash flow strength: “We are doing so well that we can afford to give our investors back some money.”
There are two types of stock returns – dividends and capital appreciation. Paying attention to dividends can satisfy your need for income or higher returns through reinvestments. Remember, though, that the company needs to have good earnings, good management, acceptable levels of debt, not-too-high volatility, and be positioned well in its industry for you to get good capital gains.
Do your research
Investing is a personal thing. Knowing what you want – capital appreciation vs dividends; local equity vs international equity; diversification vs concentration; etc. – is a good starting point to help you to decide which company’s stock is good for you.