Before investing in a stock, it is important to do your homework.
There are so many choices and variables to consider and it is easy to become overwhelmed and make mistakes.
While there isn’t a perfect recipe for success, having a guide to follow and knowing the right questions to ask before handing over your hard-earned money, will help you to make well-informed choices. It will also greatly increase your chance of making the right investment.
Below is a list of twelve questions you should be able to answer when considering whether to invest in a stock. Keep this list handy and always use it before making a decision.
1. What does this company do and how does it earn money?
You should be able to provide a simple explanation. Think about how you would explain this to a 5th grader. Having a clear understanding of the company you are investing in will help you to avoid making mistakes.
2. Has the business continued to sell the same product over the years?
If the company has been selling the same product for the past decade or two, they are much easier to assign a valuation and their staying power will be much stronger. Businesses that change what they are selling over relatively short periods are much more likely to become obsolete.
3. What does the company’s balance sheet look like?
Investing in a company with a high level of debt is never a good idea. Look for a business with a net debt-to-equity ratio that is below 50%. Also, look for those that have interest coverage ratios above 1.5. If the company ever faces a crisis and their ratios are inadequate, that company and your investment is likely to be in big trouble.
4. Can you be confident that the business’ earnings will increase over the next several years?
Look at the history of the business. Has its value risen over the past 5-10 years? If it has, you are likely to be investing in a company whose earnings are less vulnerable to inflation and are less likely to be affected by competition.
5. Is this a first-rate company?
When researching companies, you will want to focus on those that are earning high returns on capital and those that have demonstrated an ability to maintain a competitive advantage. Pay particular attention to: economies of scale, high customer switching costs, patents, government/regulatory permits, brand recognition and network effects.
6. How much risk will I be assuming if I invest in this business?
Make sure that the largest part of your investment portfolio consists of high earning and sustainable businesses. Keep speculative investments to a minimum.
7. Is the return worth the risk?
No investment is without risk. In most cases, you should look for a total return of at least 10%, taking dividends and growth in the value of the company into account.
8. Can the company convert its profits into cash for its shareholders?
Think twice about investing in a company whose free cash flow lags behind its net profit. Businesses that cannot turn its profits into cash for its investors may be businesses that are low quality or capital intensive.
9. Are the interests of the shareholders a priority for management?
Avoid companies that have overly promotional management or consistently issue shares to raise capital. You will want to invest in companies that have high insider ownership, performance-based compensation for executives and earnings per share growth.
10. Does the future of the business depend upon variables that are not within its control?
Consider factors such as interest rates, regulatory changes and commodity prices.
11. What reasons do other investors have for selling this stock?
Are you able to understand the bear case of these investors and show how their reasoning is incorrect?
12. Have you considered the worst-case scenario?
By considering the worst-case scenario, you will be able to notice potential factors that might negatively influence your investment or any errors in judgement you may be making. Always allow a margin of error when making judgements.