Five Questions To Ask Yourself Before Buying A Stock

Are you buying the stock, because your brother told you to?

Did you get a hot tip from your mailman?

Or are you just buying the stock because you like the company’s products?

Believe it or not, a very large percent of people who invest in the stock market are investing their hard earned money based on the above examples without any further research.

Does this sound like a smart way to invest to you? It certainly doesn’t to me.

Now if you ask your brother what stock to buy and your brother happens to be Warren Buffett, well then I think its safe to say you will make a good investment, but how many of us can claim Warren Buffett as our brother?

For the vast majority of us this kind of investing is very risky, while you could make money, it is more probable that you will lose money.

To help you keep from losing your money and to help you make the best choice when picking stocks, below you will find the five most important questions to ask yourself before buying a stock.

1. What Does the Company Do?
This sounds like pretty basic information, but it can be tough to find. Most companies offer more than one product; a big conglomerate might offer hundreds of different products in a range of industries. Digging into the company’s lineup can give you a better sense of the forces that will drive its results.

Scrutinizing a company’s product line cans also tell you where its profits come from. For example: video games accounted for 11% of Sony’s SNE total sales in 2000 but 40% of its earnings.

The annual report is the best source for this kind of information. Be sure to read the shareholders letter, as well as the presentations of the company’s product lines. Those are also part of the company’s SEC filings.

2. How Fast is the Company Growing
Over long periods of time, stock prices are driven by earnings growth. That can come when a company cuts costs, but ultimately, revenues have to increase if earnings are to keep going up. If revenues, also called sales, are increasing, that’s a good indication that something is working. Maybe the company boasts a better-than-average product or a more effective sales force. In contrast, flagging sales can signal trouble.

Earnings growth signifies that the company is making more that enough to offset its costs. Established companies should show consistent results, but young companies often display strong revenue growth with little or no earnings. Witness the myriad of Internet companies with lots of sales and no profits.

3. How Profitable Is It?
In addition to growth, look at how efficiently the company makes money. Return on assets shows how well it has translated a dollar of its asset base into a dollar of profits. A company with a return on assets of 20%, for example, has produced $0.20 of earnings from each dollar of assets. Similarly, return on equity measures how well the firm has turned a dollar of shareholders equity into earnings.

Measures like return on equity and return on assets help you understand how efficiently a company allocates its resources, and they allow you to look beyond raw profit numbers. Companies with the same earnings figures might have very different returns on equity and returns on assets, depending on how well they have turned their assets into profits.

4. How Healthy Are Its Finances?
Earnings and cash flow are two different things. You could earn a very generous salary but still run into cash-flow problems if you get paid only twice a year. Because of quirks in accounting practices, a company’s reported earnings often differ from the amount of cash it brings in the door. The statement of cash flows, which is part of the annual report, will tell you just how much of the money a company pocketed.

It’s also important to see how the company uses that cash. Digging into the cash flow statement to find out where the money’s going can shed light on management’s strategy and give you additional insight into the company’s future. Is it building aggressively for the future by opening new stores or building new manufacturing facilities? Is it buying other firms, paying off debt, building up cash reserves, buying back stock, or paying dividends?

Companies can also issue debt to finance new plants and research efforts or to bail itself out of short term cash problems. Companies need to watch their debt levels, though. Too much borrowing can force the company to use its cash to pay interest, instead of applying it to more productive ends.

No hard-and-fast rule will tell you how much debt is appropriate for a particular company, because levels of indebtedness can vary across industries. To get an idea of whether a company is overburdened by debt, divide its assets by its equity. The result is the company’s financial leverage.

5. Is It Worth the Price?
A company might clear all these hurdles, but sell at too high a price to be an attractive investment. It all depends on how much its prospects are worth.

To figure that out, look at its forward Price/earnings ratio, for example General Electric has a forward P/E of 41, which means that the shareholders now pay $41 for $1 of the company’s future earnings.

Another widely used measure is the price/book ratio. That shows how much shareholders are paying for $1 of the company’s assets.

Whichever ratio you use, compare it with its parallels for other companies in its industry and for the market as a whole. That will tell you how expensive the stock is, relatively speaking. Remember, stocks with very high P/E and P/B ratios can fall dramatically when any little thing goes wrong.

Analyzing stocks isn’t easy, but you will be off to a solid start if you ask these questions first before buying a stock.