4 Questions You Should Ask Yourself Before you Buy A Company’s Stock
May 16, 2018
If you were paying attention to the rise of Bitcoin in 2017, you might remember a huge influx of new investors buying the currency at extremely high prices. Bitcoin’s exponential growth from 6 cents in 2010 to $1000 at the start of 2017, and then 10x increase within one year, made the currency a very tempting buy. Chances are, you might also know someone who lost money investing in Bitcoin and wonder why that happened.
There’s a common theme among investors that often results in throwing money down the drain. One of the biggest investing mistakes you want to avoid is not doing your research on your investment choice before you buy. In the case of Bitcoin, thousands of people blindly invested their money in the currency, without fully understanding the risk involved.
As Jim Cramer advises in his book, Real Money: never purchase a stock without extensive knowledge of the company you’re investing in. Understanding how the company makes money, what the industry’s growth expectations are, and why the company is profitable is critical to best predict what return you can anticipate earning. When it comes to stock investing, here are the top four questions you should know about a company before you buy:
1: What are the company’s main attributes?
The first step of your research should be all about the company itself. Find out the main product or service the company offers and what differentiates the company from others. Explore the business model of the company to determine how they make money – are they a long-standing, established company that uses a traditional sales strategy, or are they a rapidly growing startup that does 90% of their business on Instagram? Reflect on what factors make the company successful – does the company have a loyal customer base, is it a thought leader in their industry, or does the company use an innovative business model? You should also note who the founder and main figures of the company are, as they’re likely to have the greatest influence on any changes that might occur. To start off, you can look at the company’s website and social media pages. Depending on the size of the organization, you can also read articles published about the business by external parties. To answer business-related questions, the company’s Form 10-K report for shareholders covers many of the topics discussed above.
2: What is the company’s competitive landscape?
After learning about the company independently, it’s critical to analyze the business in relation to its competitors and the industry as a whole. First, do some research on the company’s top competitors – what product/services do they offer, who is their target audience, and how is their business model different from others? Based on the number of competitors, you should be able to determine the level of competition within the industry. Does the company compete in an highly competitive market, do they have a majority of the market share, or something in between? Overall, having insight on the competitive landscapes sets you up to better forecast the company’s future in your stock decisions.
3: How does the company pursue growth?
For the short term, what you should be looking for is how the company reinvests capital back into the business. Often, companies in the introduction and growth stages are likely to spend more money reinvesting into the business, in comparison to companies in the mature and decline stages. For example, it’s not uncommon for growth companies like Tesla to undergo debt in order to fund high costs associated with research and development, product releases, marketing…, etc. By determining what growth stage the company is in, you can better predict what reinvestment strategy the company is going to take on.
There are numerous ways a business can strategize for long-term growth, such as franchising, acquiring market share, or diversification. It’s important to decipher what kind of growth strategy the company is likely to pursue, as that strategy is bound to affect the value of the company’s stock. One instance might be a strategic partnership for long-term growth that can significantly affect the value of the company’s stock; for example, news of a strategic partnership between Shopify and Amazon in 2015 increased Shopify’s stock by over 23%. You can best determine a company’s growth strategy by looking at their past history, reading recent news announcements, or examining their business model.
4: Is the company profitable?
At the end of the day, it’s all about determining whether or not a company is profitable. The best way to examine a company’s profitability is by looking at their financial statements. For a general overview of the company’s earnings and assets, use the income statement and balance sheet. The easiest way to find a company’s financial information is by looking at their personal website, using online resources such as Yahoo Finance, or visiting stock exchange websites like NASDAQ. For more information, here’s a great resource on how to read financial statements.
Stock valuation is an important part of investment research because it’s used to predict future market prices in attempt to profit from price changes. When investors want to value a stock, they often look at a few different financial ratios to assess valuation. A company’s beta tells you how volatile a stock is, which is often an indicator of the level of risk involved. The earnings per share (EPS) value tells you the amount of earnings allocated to each share of common stock. Another great ratio is look at is the P/E ratio, which compares the current share price over the amount of earnings per share. Note that a higher or lower ratio for any of these valuation metrics doesn’t necessarily mean a better buy – their purpose is to serve as a good reference point to better predict value.
The Bottom Line
No stock pick should be made without thorough research. The last thing you want to do is the make mistake of not spending time doing research on investments you’re interested in, much like the Bitcoin buyers we discussed above. Starting an investment club is a quick and great way to divide up the research among friends and rationalize your investment decisions as a team. Download the Voleo app and start an investment club with your trusted circle of friends today!