Investing is one of the best ways to grow your wealth, but it carries the risk of losing money as well – especially when picking companies to invest in.
To help you avoid costly mistakes, let’s break down what you need to know before investing in any company.
Study a Company Before Investing in Its Stocks
Picking a stock solely based on social media trends or current events is a losing bet. You can’t be truly confident in your investment without studying the details of a company. Learn about the leadership, business model, financials, and future business plans to discover insights into how your stock may perform over the coming months and years.
What To Look for When Investing in a Company
When selecting a stock to invest in, do your due diligence by researching these 8 areas:
1. Start with the Chief Executive Officer
At the helm of any publicly-traded company is the CEO. Confidence in this business professional can be a very telling sign of the future success of a company. Not only do CEOs help determine the strategic direction of a company, but they can also make or break the business with their decisions.
What to look for: A CEO should have a track record of savvy business moves on their resume. One of the quickest ways to learn more about a CEO is through their LinkedIn profile or the company “About Us” page.
Check out their career moves and details of how they helped their previous companies (and current company) grow. Ask yourself how their experience qualifies them to lead this company in the future.
If the CEO is the founder of the company, consider how the company would fare if they suddenly stepped down. Does the company have a bigger reputation than the CEO?
2. Review the Company Business Model
How a company makes money is referred to as its “business model.” While there isn’t a single way to run a business, successful companies should be positioning themselves to maximize profits.
What to look for: When researching a company’s business model, learn about its products and services, target market, and the industry it’s competing in.
Some companies (such as Amazon) are going after a wider audience with low prices and higher volume sales. Other companies (such as Apple) create exclusive devices that users gladly pay a premium for.
Many business models can be successful, but make sure you understand – and agree with – how the business is run before investing.
3. Consider What Competitive Advantages a Company Has
All businesses are competing for their customers’ business, and a successful company will continually have an advantage over the competition. This is the company’s “secret sauce,” or the thing that makes customers choose a particular company over everyone else.
What to look for: Amazon is a fantastic example of a company with a strong “economic moat.” Amazon changed the retail industry with free 2-day shipping, causing competitors to lose business quickly because they couldn’t promise to beat Amazon’s price or shipping guarantee.
A company with an edge over its competition is a promising sign of finding a good stock to invest in.
4. Examine Revenue Trends and Price History
Revenue is the total sales of products and services that a company brings in, usually reported on a quarterly basis. Evaluating a company’s revenue history can show you whether the company is growing or in decline.
What to look for: When reviewing revenue trends, a year-over-year increase is a sign that companies are making the right moves and have strong sales strategies. While increasing revenue each quarter isn’t always realistic, seeing a decline over multiple consecutive quarters may be a troubling sign for investors.
Stock price history is another excellent indicator about company performance. Seeing an upward trend over a multi-year period – especially if it correlates with smart business moves and increasing revenue – is likely a sign of a growing company. Remember: There are always ups and downs with the price of any stock, and historical stock prices are not always a guarantee of future results.
5. Assess Net Income Growth Year to Year
Reviewing the net income (a company’s revenue minus expenses and depreciation) can also be a good indicator of company growth. This is the “bottom line” number that shows whether a company is profitable or not.
What to look for: If a company has decreasing net income year-over-year, its growth may not be sustainable. This could be a sign that its expenses are increasing too quickly and business operations are inefficient. If the net income is increasing over time, this is a good sign that the business is operating efficiently and growing.
The ultimate goal of any company is to make a profit, and that directly impacts the stock price as well.
6. Examine the Profit Margin
Sometimes referred to as net profit margin, profit margin is the percentage of revenue that the company takes in as profit (after expenses, interest, and taxes have been paid). A company's net profit margin is the net income as a percentage of total revenues.
For example: If a company has a total revenue of $10,000,000 and a net income of $1,000,000, its profit margin would be 10%.
What to look for: A company with steady profit margins means it is operationally efficient and can keep prices low. Increasing profit margins may signal that a company is a leader in its industry and can command higher prices for products or services.
Steady and/or growing profit margins are a good sign for investors, as those profits should reward stakeholders with returns.
7. Compare Debt-to-Equity Ratio
When researching company financials, take a look at the debt-to-equity ratio to see how well the company manages its total debt. To find the ratio, compare the total debt to the total equity shareholders have in the company.
For example: If a company has $10,000,000 in debt and the total equity of all the shareholders is $20,000,000, it would have a 1:2 debt-to-equity ratio.
What to look for: Being over-leveraged can limit a company’s choices in making business decisions. A good rule of thumb is finding a company that has a 2:1 (or less) ratio, meaning that a company derives 66% or less of its funding from debt and 33% or more from shareholders.
The lower the debt ratio, the more a company can take risks without the worry of defaulting on its large debt load.
Note: Debt-to-equity ratios vary by industry, so be sure to research industry standard D/E ratios before judging whether a company is over-leveraged.
8. Analyze Price-to-Earnings (P/E) Ratio
The price-to-earnings ratio is a key indicator of whether a company’s stock is currently overpriced. To find the P/E ratio, compare the current stock price to the annual earnings-per-share (EPS). To calculate EPS, take the net profit and divide by total outstanding shares.
<p>Example: A company with a net profit of $4 million and 10 million outstanding shares of stock has an EPS of $0.40 per share.</p>
<p>Take the current $10 price of the stock, and divide that by $0.40, and you’ll get a P/E ratio of 25.</p>
<p><strong>What to look for</strong>: When evaluating any company, compare its P/E ratio to the current industry average. A higher P/E ratio may be a sign that the company is currently overvalued. A lower P/E ratio may be a sign that the company is currently undervalued. </p>
<p>Finding undervalued companies is what defines a “value investor,” which has historically worked well for investing greats such as <a href="/articles/benjamin-graham-father-value-investing">Benjamin Graham</a> and <a href="/dictionary/w/warren-buffett">Warren Buffett</a>. On the other hand, sometimes there is a good reason that the stock price is low… such as less efficient operations or a heavier debt load, so be sure to look at all the factors outlined above.</p>
What You Need to Research Before Investing for Yourself
Now that you know what to look for in a company, there are a few things to review before investing.
What are your goals for investing? For most people, retirement is at the top of the list,
When setting a financial goal, always provide a total amount to save and an end date. These two factors will determine how much you will need to invest each month to reach your goal.
Example: You want to retire at age 60 with $1 million. If you’re currently 35 years old, you’d need to reach this goal in 25 years.
To save one million dollars, it would require investing $1,250 per month for 25 years at a 7% rate of return.
Creating goals this way will help you understand what amount you need to save – and what rate of return you require to hit that goal.
Risk tolerance is the amount of volatility you’re willing to take on with your investments. Understanding how you’ll react if your portfolio drops of 10%, 20%, or more will help inform how aggressively you can invest without losing sleep (or worse, selling at a steep loss).
When investing in individual companies, there’s always a downside risk that the stock price could plummet and you’d lose money. If you’ve done your due diligence when researching your investment – and can handle seeing the price of your investment go up and down over the short-term – you may have a high risk tolerance.
If seeing the stock price drop by 5% or 10% in a week makes you want to sell immediately, you may be risk averse and should consider avoiding investments in individual companies.
You Current Portfolio Mix
When picking stocks, understanding your total portfolio mix will help you choose how much to invest. Diversification is key to any long-term investing strategy, and balancing your current investments with your single company stocks will help you spread out your risk.
If you’re currently invested in single stocks, index funds, and bonds, calculate how your new investment fits into your portfolio mix. If adding another single stock makes your total portfolio riskier than you’re comfortable with, consider shifting some funds into fixed-income securities to balance it out.
Your Portfolio Management Style
Your portfolio management style will help you with stock picking. Are you a hands-on investor or a bit more passive?
If you’re going to be actively trading stocks every day, you may be more comfortable with carrying out company research and picking a few winning stocks. If you prefer passive investing, you may prefer to stick with index funds that invest in hundreds of companies, then follow the movement of the greater market.
Your Time Horizon
How long are you willing to stick with an investment? Are you looking to generate a return within a few days or are you happy to let your investment grow over a few years (or more)?
Understanding your time horizon will help you pick the right investment. Whether you’re actively trading stocks or want to pick a good long-term investment, knowing your timeline for any investment will help you stay the course.
The Key Takeaway For Beginner Stock Picking
Before diving in, researching your investments will help you avoid the pitfalls that less-experienced (and sometimes veteran investors) run into.
Bottom line: Find companies that:
you understand (and agree with) from a leadership and business perspective
operate with strong management and financial health
are trading at a good value.
These will be key to your investing success.