There are many things that pique an investor’s interest in a stock. It could be an article on the internet, or a segment on business TV. Or it could be that they notice a new product or service that they think will be a big success and look for the company behind it. Whatever firsts grabs your attention though, you should get in the habit of never parting with any money to buy a stock without first doing a little research. "Research" may be a daunting word to many people, but it isn’t really that difficult. There are four things that you should check.
The Other Side
The first thing to do is to seek out the opposite view to your own. Your idea may seem so obvious to you, or the logic of a pundit like myself seem so convincing, that it is easy to forget one basic fact: When a stock trade is executed, there is a buyer and a seller, and both are acting in what they believe is their best interest. As strongly as you may feel that a stock is a buy, somebody somewhere feels just as strongly that it is a sell.
For most stocks traded on a major exchange, a simple internet search will reveal a host of articles, some positive and some negative. Read a representative sample of both. Sometimes the opposite view makes more sense than your original opinion, or at least as much. If that is the case, stop there and look for something else to buy.
If you are still convinced that your idea is sound, it is time to start researching the company whose stock you are considering.
Start by considering whether it represents value. For some newcomers to the market, that is a difficult concept to grasp. The most common mistake I hear, often from people I think would know better, is the assumption that price alone is an indicator of value. A stock is not “cheap” just because a stock is trading at a low dollar value. The number of shares that have been issued varies from company to company as well.
For example, let's say there's a fictional stock called ABC trading at $5, and another fictional stock called XYZ trading at $50. If ABC has 100 million shares in circulation and XYZ 10 million, you would have to buy 10 shares of ABC to have the same percentage ownership of the company as you would get by buying 1 share of XYZ. In other words, the price of a stock is not the same as its value.
Value is not just a matter of price. What matters is how that price compares to the company’s earnings. That is measured by what is called the Price to Earnings, or P/E ratio. The simplest form of P/E is calculated by dividing the price of the stock by the sum of last four quarters’ earnings per share (EPS), known as trailing P/E. For example, if a company has made $1 for each share issued in each of the last four quarters, and the stock is priced at $20 it has a P/E ratio of 5 [20/(4x1)]. (For more on P/E, check out this article)
The lower the P/E ratio, the better value the stock represents, but it is not that simple. If a company’s sales and profits are sinking, the P/E will be low as they are not expected to match past earnings. Forward P/E, which uses Wall Street analysts’ forecasts of profits for the next year to get the earnings part of the equation, takes potential growth into account, but keep in mind that it is derived from an estimate, not historical fact.
News & Prospects
You cannot accurately anticipate all the news that may derail your idea, but you can avoid nasty surprises with a little research. Has the company been involved in any trade rumors, either as a buyer or a target? Are there upcoming political or geopolitical events that could affect their industry? What is the general economic outlook? There are a host of questions that could come up, but once again, Google is your friend here.
Just one note of caution though: keep in mind the source of the information. A report from the Wall Street Journal or a reputable website is more reliable than one from a site you have never heard of, or a site that trades in ideological thinking. It should also be noted that anything posted on a message board or social media (Twitter, Reddit, etc) should be taken with a large pinch of salt.
Liquidity & Cash Flow
Most people have heard of a “solid balance sheet” but I am sure many don’t really know what that is. Simply put, it is when a company has assets that outweigh their liabilities. The biggest liability for a company is usually its debt, so check how much debt the company has in relation to its size. The fastest, easiest way to do that is to look at the “current ratio” which is calculated by dividing current assets by current liabilities. If the number comes out to less than 1, it could mean that the company has some liquidity issues.
Even if that is the case, though, it doesn’t necessarily mean that you shouldn’t invest. If the business is generating a lot of cash they can easily service their debt and still have enough left over to reduce liabilities and invest in growth, so is still worthy of consideration. Cash flow should therefore be considered alongside liquidity.
There was a time when finding out all these things was difficult and time-consuming, but that isn’t the case now. The opinions and news will pop up if you search the ticker symbol, and things like the P/E, current ratio and cash flow can be found by entering the ticker right here on this section on Nasdaq.com, or clicking on the “statistics” tab or something similar on sites like Yahoo Finance. You must remember not to believe everything you read on the internet, but you can generally trust the stats and avoid getting caught out by looking for a variety of views, not just those that confirm your opinion.
Face it, you wouldn’t buy a car or a house, or even pay for a vacation without doing some research, so why would you buy part of a company without doing the same? Make it a habit to check these four things before you invest, and you will avoid a lot of mistakes.