It may seem like a given that you should do your homework before plunking down your hard-earned cash on a company’s stock — but many people don’t.
“There are some investors who simply don’t carefully weigh their stock-investment decisions,” said Brad Barber, University of California Davis professor and co-author of the study All That Glitters: The Effect of Attention and News on the Buying Behavior of Individual and Institutional Investors. “Individuals are heavy buyers of stocks that are in the news — that is true of good and bad news,” he said.
As stock market crashes have taught us, a carefree investing style doesn’t work forever. In fact, its success usually comes to an abrupt end. It would behoove investors to relearn that painful lesson before the next crash.
With that in mind, here are 10 questions investors should ask — and answer — before buying a stock.
Of course, knowing all the answers doesn’t guarantee a winning stock. Nothing can do that. But over the long haul, taking the time to consider these questions will make one a better, more well-informed investor.
What Does the Company Do?
Warren Buffett famously says he doesn’t invest in what he doesn’t understand. If the greatest investor of the past 60 years is brave enough to acknowledge that he doesn’t understand all companies, we should all probably take heed. This first basic question is a simple one, but that doesn’t mean it’s easy. To answer the question, there are plenty of places to look, including the company’s Web site.
Is the Company Profitable?
This is also a simple question, which can be made more complicated by all sorts of variations on a company’s earnings. Investors can read the quarterly and annual earnings reports to check out how much net income the company reported, in dollars and in per-share earnings. Later down in this column we’ll address ways to mine for red flags in earnings.
What Is the Company’s Earnings History and Outlook?
A quick scan of older news stories and the company’s past quarterly statements help answer this question. Does the company have a history of steady earnings growth? Are earnings volatile? Remember, all trees don’t grow to heaven: If the company is a maturing tech company, can it sustain the heady growth of its days as a spry, young growth company?
How Richly Is the Company’s Stock Valued?
It’s wonderful to find a company whose earnings are growing exponentially, but the other side of the equation is the value the market pays for that growth and the prospect of future growth. There are several basic methods of determining a company’s valuation, including price to earnings and price to sales. These numbers can be easily found online . Price-to-earnings, or P/E, multiples aren’t the perfect gauge, but investors do need to consider how much they are paying for a stock.
Who Are the Company’s Competitors?
Companies don’t operate in a vacuum. For every Coke (KO), there’s a Pepsi (PEP) — and a host of other competitors as well. Companies are constantly trying to take business from one another.
Investors should know where their companies stack up: Does this company have the biggest market share in its industry?
Is it a small but growing niche player in a competitive industry? Is it an industry dominated by one company, or is it a fragmented industry where even the biggest player controls less than 10% of the market — such as in the supermarket business?
Also, investors should increasingly pay attention to foreign competition, where lower-cost competition can put pressure on profit margins.
Who Runs the Company?
Unlike professional money managers, individual investors don’t have the ability to drop by a company’s headquarters and chat up the management before making an investment decision.
However, that doesn’t mean there aren’t plenty of ways to find out about the leadership. Any company worth its salt will have a Web site that lists the senior managers, how long they have been with the company, their background and the company’s history.
If the company’s executive suite has a rotating door, that may not reflect positively on the company’s stability. Beyond the company line on the executive suite, investors should research articles about the executives. Often, trade publications from any given industry are useful in digging into a company.
How Clean Is the Company’s Balance Sheet?
Serious-minded long-term investors need to be able to read over a company’s balance sheet. Is the company saddled with a huge amount of debt compared with how much it earns? Checking out a company’s earnings alone doesn’t tell you if the company has borrowed to the moon to achieve those earnings. It’s also useful to see how much the company is spending on research and development and how large its inventory levels are. (If they are growing from last year, that may mean business is slowing down.) This brings us to question No. 8.
Have You Read the Company’s 10-K and 10-Q Annual Reports?
The 10-K report is the annual report every company is required to file to the Securities and Exchange Commission. It’s much more in-depth than the more sanguine annual reports that companies file during earnings season. The 10-Q is the quarterly report — similar to the 10-K report except that it is required on a quarterly basis.
Are There Any Red Flags That Call Into Question the Company’s Integrity?
This is where the 10-Q and 10-K filings come in handy. First off, every company needs to detail the risk factors that may undermine its prospects. Second, the explanations of the company’s accounting practices and operating assumptions on matters ranging from depreciation rates on its assets to assumed rate of growth for its pensions tell you a great deal about whether the company is getting too aggressive.
Is the Company’s Competitive Position Sustainable?
Run-and-gun investors looking for short-term gains might not need to answer this question, but serious-minded long-term investors do.