Rule No. 1 - Do your homework before buying stocks.
Experienced investors consider the following factors when picking stocks, and so should you:
- What are the trends in a company’s earnings growth?
- What is a company’s strength relative to its peers?
- Is the debt-to-equity ratio in line with industry norms?
- Price-earnings ratio can help provide market value
- How does a company treat its dividends?
- Is the executive leadership effective?
- What is the company’s long-term strength and stability history?
When you begin to identify stocks for investment, it’s crucial that you do your homework. Your goal is to find good value – particularly if you plan to hold on to an asset long-term. Rather than acting on a whim or hearsay and put your faith in a company, you should do thorough research. You need to review a stock’s fundamentals to gauge its viability and suitability for your portfolio. Don’t think of it as a simple stock purchase – you are becoming a shareholder of a company, so must be willing to do the proper analysis. Yes, it can be time-consuming, but it is well worth the effort. Here are some things you should know about a company before investing your hard-earned cash and savings.
What are the trends in earnings growth?
Study the trends in a company’s earnings growth. Do the earnings generally increase overtime? Even small but consistent improvements over a long period which can be a good indication that the company is doing something right. But earnings growth has to go hand in hand with value for the stock to be worth the investment. Assessing a company means understanding how the business works and how valuable its future cash flows will be. This involves evaluating its products and services, its target market and its cost structure. This will enable you to determine a company’s competitive advantages, its market opportunity and the sustainability of its cash flows.
Assess a company’s strength relative to its peers
Look at other companies in its industry to see how it is represented in the market and establish if there is future growth potential. Industry competition can be a great screener when investing. You need to assess where the company fits in. How does it fare against its competitors? Does it have an advantage that makes it to stand out? When comparing a prospective company to its peers 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. Compare competitors of the same size or market capitalisation and review their performance during the same time period.
Is the debt-to-equity ratio in line with industry norms?
All companies carry debt – some of the biggest most successful companies can carry eye-watering levels of debt. But you can also use debt as an indicator of the company's financial health. You need to be wary of companies with high-debt levels relative to their equity (its debt-to-equity ratio). To calculate 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 stock pick is in line with industry norms.
Price-earnings ratio can help provide a market value
The P/E ratio is a valuation metric that measures how well a stock’s price is performing relative to the company’s earnings which is 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 pay-out consistently each year for decades. Watch out for companies that have very high yields, though. A high 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 tough economic times. An example of this is that many major companies stopped paying a dividend during the Covid-19 pandemic. This doesn’t necessarily mean the company is in jeopardy, but rather the business may require more cash to meet immediate expenses and investors needn’t be worried initially. Sometimes the company or industry reduces or stops the dividend because it's in permanent decline and such can be an indication of worse to come, but other times it can be that they're in temporary difficulty, which many companies experience from time to time. So 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 investors need an understanding of a company’s culture of employee and customer satisfaction, brand recognition and loyalty, and factors such as revenue growth, profitability, cash flow, debt levels. Understanding this information can help investors understand a company's prospects and the direction management is taking, critical information to help in your stock-picking decisions.
Assess the long-term strength and stability
The stock market is volatile by nature. Periodically, a company is likely to lose value in the markets in the short term. More important is their long-term stability. Generally, trend lines smooth out over the long term and the market heads higher again. Look for that with individual companies too. A company that manages occasional downturns and can return to strength even despite of a market downturn, is a company worth your consideration and research time.
Summary
A stable company will demonstrate strong characteristics of the factors discussed above: it grows revenues, maintains low levels of debt, is competitively in its industry and has effective leadership. These are some of important factors to look out for when stock-picking. If one of these variables is absent or changes, investors should take note and determine if it’s a stock worth buying or one to avoid.
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