With nearly 4,000 publicly traded companies in the United States, selecting the right stocks can be a daunting task for investors. However, before committing your hard-earned money to any company’s shares, it’s essential to ask pertinent questions that could spell the difference between a lucrative investment and a disappointing outcome. Here are key inquiries to make before making a stock purchase:
- What is the company’s core business?
Understanding the fundamental operations of the company should be your initial inquiry. While it may seem straightforward, some investors become enamored with the hype surrounding a company without grasping its foundational principles. To make an informed investment decision, it’s crucial to comprehend how the company generates revenue. Without this understanding, evaluating its investment potential becomes challenging. Conducting thorough research typically provides insight into a company’s operations. However, for exceptionally complex or opaque companies regarding revenue sources, exercising caution and refraining from immediate investment may be prudent. History has shown that companies with obscure revenue models often lead to significant stock market failures, as exemplified by the Enron scandal.
2. What are the company’s revenue and earnings figures?
A crucial aspect influencing a company’s stock price is its financial performance, with revenue—reflecting the company’s income—and earnings—synonymous with profit—being paramount. While higher figures are generally favorable, it’s imperative not to assess revenue and earnings in isolation. Comparing these metrics to previous quarter and year-over-year figures, as well as benchmarking against industry competitors, provides valuable context.
Furthermore, investors should delve beyond total earnings and scrutinize earnings per share (EPS), calculated by dividing total earnings by the number of outstanding shares. For instance, if a company’s earnings amount to $20 million with 10 million shares, the EPS would be $2. Evaluating EPS in relation to industry norms aids in gauging the company’s performance relative to its peers.
Analyzing revenue and earnings offers insights into the company’s financial well-being and aids in investment decision-making.
- What is its historical performance?
While past performance doesn’t guarantee future returns, a robust track record of consistent, favorable returns often bodes well for stocks. Stocks boasting decades of reliable performance instill confidence in investors, whereas those with shorter track records may entail greater risk.
When assessing a stock, scrutinize its returns over the preceding five- and ten-year periods, seeking historical data that extends further back whenever possible. A timeframe shorter than three years typically lacks sufficient data for sound analysis.
- Does it offer dividends?
Many companies opt to allocate a portion of their earnings to shareholders through regular dividend payments. These dividends, disbursed quarterly, serve as a lucrative source of passive income for investors. Healthy companies demonstrate their financial strength by distributing sizable dividends, though some prioritize reinvestment of earnings over dividend payments—Amazon being a prominent example.
In general, companies with substantial dividend payouts tend to exhibit stability but slower growth. Utility firms often fall into this category. For investors nearing retirement, dividend stocks may feature prominently in their portfolio, safeguarding savings and providing income post-retirement. Conversely, those with a longer investment horizon might favor growth-focused stocks over dividend-yielding ones.
- What is its price-to-earnings ratio (P/E ratio)?
Assessing whether a company’s stock price is appropriately valued can be challenging. However, a helpful metric to consider is the price-to-earnings ratio (P/E ratio), which compares the stock price to its earnings per share. While there’s no universal benchmark, it’s advisable to avoid excessively high P/E ratios, as they may indicate overvaluation. P/E ratios deemed reasonable can vary across industries; for instance, a growing tech firm might have a P/E ratio exceeding 20 and still be considered reasonably priced, whereas a manufacturer with a ratio of 10 might be overvalued.
When researching a stock, compare its P/E ratio to those of competitors within the same industry and the broader market. This analysis can help identify undervalued stocks or signal overpriced ones.
- What is its market capitalization?
Market capitalization, essentially the company’s size, is calculated by multiplying the total number of outstanding shares by the share price. Large-cap companies typically have market capitalizations exceeding $10 billion, while mid-cap stocks range from $2 billion to $10 billion, and small caps from $300,000 to $2 billion.
A well-diversified stock portfolio should encompass a mix of large, mid-sized, and small companies. Larger firms typically offer stability suitable for long-term investing, whereas smaller companies, particularly in sectors like technology, may yield higher short-term returns but exhibit greater volatility. Understanding a company’s market capitalization aids in gauging its growth potential.
- Does it have domestic and international operations?
Assessing a company’s revenue sources across geographic regions provides insight into potential growth opportunities. As the U.S. represents a small fraction of the global population, companies with expanding international operations may indicate room for growth.
A diversified portfolio should include exposure to international markets. Investing in U.S.-based companies with significant overseas operations may obviate the need for direct investment in international firms.
- Does the company possess a “moat”?
Renowned investor Warren Buffett often references a company’s “moat,” symbolizing its competitive advantage and resilience during challenging times. A moat can encompass various factors that set a company apart, such as brand strength or proprietary technology. Companies like Walmart, known for its low-priced products, and Facebook, boasting a vast user base, exemplify wide moats.
When evaluating a stock, consider that a wider moat signifies greater resilience, which is advantageous for investors seeking stability and long-term growth.
