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Many investors buy stocks on a whim, either because the stock is hot or at the suggestion of a financial pundit. Most of us don’t have the ability to research stocks full-time, so impulsive buying may seem reasonable.
Still, it’s useful to have at least a baseline understanding of what you are buying. Investing always involves some risk, but asking the right questions can help make your portfolio’s performance a bit less volatile.
Before buying your next stock, ask yourself these 8 questions first.
Questions to answer before investing in a stock
1. What does the company do?
Ideally, having a basic understanding of what the company does is crucial. For example, suppose you are considering a business that manufactures conduits for refrigeration and heating systems. It isn’t necessary to know every step of the manufacturing process, but you should have some idea of what those conduits do. If you don’t, it may be best to explore other investment options.
2. Is the company profitable?
There are many reasons you might consider investing in a company. Perhaps the business is an exciting startup or a big name that has been around for generations. But the reality is that companies that fall into either category could lose money. If a business consistently loses money, it might be at risk of insolvency, so it should be avoided.
To determine whether the company is profitable, you can read quarterly and annual reports, which all publicly traded companies must file with the SEC. In these reports, you will find figures like net income, net profit margin, and net change in cash. If these numbers are regularly positive, it’s a sign that the company is headed in the right direction financially.
3. What are its EPS and P/E?
Another set of numbers to investigate is the price-to-earnings (P/E) ratio and earnings per share (EPS). These will give you a clue as to whether the company is overvalued or undervalued. For instance, the business might be overvalued if its P/E ratio is high because the price is high relative to company earnings. But if its EPS is high, it might be undervalued because it has a high amount of earnings for each share. Whether these numbers are high or low is relative to the company’s direct company’s competitors. Thus, the standards might be different for different industries.
4. Who are its competitors?
Just like a business should know its competition, so should its investors. Knowing the competition is important as an investor because it can clue you into possible challenges from the competition. If the company you are considering operates in an industry with fierce competition, there could be constant threats to its bottom line. That could hurt its profitability and thus its long-term viability as an investment.
5. How does the company differentiate itself?
On the note of competition, businesses must be able to differentiate themselves. If it does nothing to differentiate itself from the competition, its profits could be further threatened. Again, this depends upon how competitive the industry is. If this is an industry dominated by one or two powerhouses, you may not have to be too concerned about competition. But if you are dealing with a highly specialized industry with many players, stiff competition could eventually threaten the company’s profitability.
6. What are its plans for the future?
It’s not uncommon for businesses to discuss their plans for the next year or two. Perhaps they have major products or services they intend to release soon, or maybe they are working on some mergers and acquisitions. Look for press releases and news reports with information about their plans for the future. If you find information about several upcoming projects, it’s a good sign that your company is working tirelessly to remain competitive.
7. Does it give back to investors?
Does the company you are considering give back? In the form of dividends, that is. Often, businesses that have been around for decades in mature industries will issue dividends regularly. On the other hand, if it’s a startup in an emerging industry, it may not issue dividends because it’s investing heavily in research and development (R&D). While there are pros and cons to either scenario, it’s good to set proper expectations as an investor.
8. Are other investors bullish?
Some stock analysis platforms will give you clues about investor sentiment. In some cases, you might see information about both short-term and long-term sentiment. If investor sentiment is strong across the board, it might be a sign that you’re looking at a good investment opportunity. However, investors are not immune from herd behavior, so this shouldn’t make or break your decision. Nevertheless, it’s another factor to consider as you weigh some of the others mentioned earlier.
While it might be tempting to buy whichever stock is hot at the moment, it pays to be more methodical in your approach to investing. Instead, ask yourself key questions about the company itself, as well as its profitability and competition. If the stock looks strong after asking yourself these key questions, you might have a strong investment opportunity. If not, it might be best to look elsewhere.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.