10 Questions to Ask Before You Buy a Stock
NEW YORK (TheStreet) -- 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, according to a new study.
"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 recent 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 the stock market crash of 2000 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, today's column offers 10 questions investors should answer before buying a stock, with some input from Pat Dorsey, Morningstar's director of stock analysis and author of the recent book The Five Rules for Successful Stock Investing.
Some of the questions may see pedestrian to more seasoned investors. If so, humor us a little with our refresher course. And, of course, knowing all the answers doesn't guarantee a winning stock -- in fact, nothing does. But over the long haul, it will make one a better, more well-informed investor.
No. 1: What Does the Company Do?Go ahead and laugh. Then explain to me how JDS Uniphase's source lasers help expand the brave new world of fiber-optic telecommunications. Warren Buffet famously says he doesn't invest in what he doesn't understand; if the greatest investor of the past 50 years is brave enough to acknowledge that he doesn't understand all companies, there must be some wisdom contained within. 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 and the fine site that Hoovers maintains.
No. 2: 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. Tyco and the slew of other scandals of the past few years drive home the notion that reported earnings aren't always kosher, but later down in this column we'll address ways to mine for red flags in earnings.
No. 3: 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 like Cisco or Microsoft, can it sustain the heady growth of its days as a spry, young growth company?
No. 4: How Richly Is the Company's Stock Valued?It's wonderful to find a company such as eBay 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: Price to earnings, price to sales, etc. These numbers can be easily found on Yahoo!, Morningstar and a slew of other Web sites. While price-to-earnings multiples, or P/E multiples, aren't the perfect gauge, investors need to consider how much they are paying for a stock.
No. 5: Who Are the Company's Competitors?Companies don't operate in a vacuum. For every Coke, there's a Pepsi -- and a host of other competitors as well. The 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 -- such as, say, International Game Technologies in the slot-machine market -- 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.
No. 6: Who Runs the Company?Unlike professional money managers, individual investors don't have the ability 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.
No. 7: 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, 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.
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 filing to the Securities and Exchange Commission -- it's much more in-depth than the more sanguine annual reports that they 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. The 10-K and 10-Q are extremely important for serious investors; at the very least, you should read the most recent offerings. If this seems like too much homework for some investors, perhaps they are better off avoiding individual stocks and should stick to low-cost index funds.
No. 9. Are There Any Red Flags That Call Into Question the Company's Integrity?Again, 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. Lastly, as Michelle Leder expertly details in her book Financial Fine Print, the footnotes in 10-K filings are a trove for red-flag hunters -- consider Enron's problematic footnotes on its off-balance-sheet accounting. Her book and Web site are a decent place to start.
No. 10. Is the Company's Competitive Position Sustainable?Or as Morningstar's Dorsey puts it, "Given sufficient funding, can someone easily replicate what they do?" Netflix rose nearly 400% in 2003 as its online video rental service took off. But the biggest question about the company's viability isn't the growth of the online video industry, but rather if a Wal-Mart or a Comcast decides to muscle in on the business. Netflix may or may not have a sustainable competitive advantage. But Netflix investors do have to give answer -- indeed, investors in all stocks need to be able to answer this question. Run-and-gun investors might not need to answer these questions, and that is fine: I don't have any useful advice on that investing style. But serious-minded, long-term investors need to answer the 10 questions above before buying a stock. In truth, these aren't the only questions an investor needs to answer; they are just a starting point. There are dozens of questions that are specific to the company and the industry that shouldn't go unanswered. Lastly, the questions need to be revisited after the stock is purchased to make sure the answers still hold up.
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