Buying a stock means investing in a company. That may seem like an obvious statement, but in fact it's a truth that's sometimes easy to miss.
When we pick stocks or mutual funds, what we see are the numbers. Pulling up that asset's information will give us data on its share price, history, volatility and more. All of that crucial data comes in the form of numbers that can hide the fact that what we're really doing is buying partial ownership in a business.
Now, it's important to remember that most of the time you should probably be putting your money into funds and other mixed-asset vehicles. Stocks can be speculative, and it's generally a very high-risk strategy to sink your money heavily into individual equities. However, buying a stock can be a strong choice for more speculative section of your portfolio.
Before you do so, there are a few crucial things to consider.
What to Look for When Investing in a Company
1. Your Financial Goals
What do you want to accomplish?
Before making any investment, consider your overall financial goals. Are you investing for your retirement, to buy a house or for some other specific purpose? Is this a general savings investment? What would you like to do with this money, and how quickly would you like to access it as needed? How much do you need this money to grow, and how easily could you replace any losses?
All of these issues and more will inform your financial plan. For most investors the best option is to build a plan that involves long term holdings, so the odds are you'll want a stock that will pay off over years rather than months. However, that's the general rule. Make sure your investment meets your needs, not someone else's.
2. Current Portfolio Mix: Risk
How many conservative investments do you have? How many risky ones? And what is the balance you would like to achieve in your portfolio?
Before investing in any company, make sure to consider how it would fit into the overall scheme of your financial risk-balancing. This is something you should always have an eye on. If a company has a particularly volatile history, this could indicate a high risk/high reward stock. For someone with plenty of risk tolerance or a portfolio already heavy with indexed mutual funds and bonds, that might be just what they need to add a bit of growth. On the other hand, if you already hold several speculative investments it might be time to consider rounding your portfolio out with a little more stability.
3. Current Portfolio Mix: Diversification
Too, before buying any stocks you might want to look at how many individual and bundled equities you already own.
Diversification is one of the keys to a successful portfolio. For investors who don't want to play the game, and who have a decent amount of time for their money to grow, focusing on an S&P 500 index fund is often a sound approach. It's certainly better than leaving all your money sitting in a savings account. If you're willing to work a little harder, though, you can mitigate a lot of risk by making sure to spread your money across a variety of industry and asset types.
If you already own several tech stocks, for example, consider putting money in a different business model instead of buying another. If you already own a lot of stocks and stock-oriented funds, consider buying some funds based on bonds or commodities. Owning several asset classes can help you make sure that your portfolio is better insulated from systematic risk.
4. Dollar Cost Averaging
In its guide on investing, the SEC refers to dollar cost averaging as "a consistent pattern of adding new money to your investment over a long period of time."
This approach means that, instead of investing your money all at once or in lump sums, you spread your share purchases out over time. For example, you might put $100 per week into a stock over 10 weeks instead of putting in $1,000 all at once. The goal of dollar cost averaging is to take advantage of volatility. Ideally you will buy more shares of your stock when the price is low and fewer when it's high, allowing you to maximize your profit.
Dollar cost averaging has the most use for moderate or high volatility stocks. With an equity experiencing steady growth, you probably won't want to take this approach because it's more likely that you'll simply pay more each time for your stock. With speculative assets, though, it can be a winner.
5. Corporate Leadership
What does this company's leadership team look like?
Before investing in a company, look carefully at who's in charge. How much experience do they have in this industry? Have they run the company for a long time, or does the firm experience frequent shifts in leadership? Are they well regarded in their industry? How much do they tend to focus on their company as opposed to, say, their social media account and personal celebrity?
Strong leadership is essential for any company, but it is particularly crucial for ones that hope to achieve long term stability and growth. As an investor, that's usually what you want, so make sure not to miss any potential red (or green) flags.
6. Business Model and Corporate History
Not to put too fine a point on it, but how long has this company been around? And how well have they worn with age?
Corporate history is more than just a number, but companies with decades of experience will often provide more steady growth than new entrants into the field. It's crucial to understand that past results are not promises of future gains, but they also can indicate a company that knows what it's doing and has worked out the kinks in its business model.
But pay attention to that business model too. When a company has spent years solving its problems and honing its routine, that can indicate a terrific asset. But that same history could just as easily indicate a firm unable to evolve and keep up with the marketplace. Look carefully at your company's business model before you buy in. It might keep you from boarding a sinking ship.
7. Price History and Volatility
Of course the numbers do matter. Just because we left them toward the end of this list doesn't mean you should blow off the data on how your company has performed in the market.
Look at the price history for your chosen company. How expensive is it? Will that allow you to buy enough of it? Remember that when it comes to stocks, your profit comes from percentages. If you invest $100 into a stock worth $50 and it goes up by one point, you'll make $2. If you invest that same amount of money into a stock worth only $5, you a one point increase will net you $20. That's not to say hit the penny stocks like a slot machine, there's a reason high-value stocks are worth more. It's just a caution not to get too excited about buying a piece of Google (GOOGL) - Get Report just yet.
And while you're at it, pay attention to the company's volatility. Make sure this stock's price history matches your risk tolerance. If the price has been all across the map then it might be a good investment for speculators, but maybe hold back any money you can't afford to lose.
8. Ratios: P/E and D/E
The P/E and D/E ratios are two of the most fundamental metrics you should consider before investing in any stock.
A P/E is the company's price-to-earnings ratio. This is the ratio of the company's current stock price to its total profit (or "earnings") per outstanding share. So, for example, if a company's stock sold for $30 and it had a profit of $2 per share, its P/E ratio would be 15x.
The P/E ratio tells you, in a nutshell, how much investors are willing to spend to access each dollar of a company's profits. In our example above, it means investors will spend $15 for every $1 in profit the company has. The higher this ratio, the more confident investors are about the company. In general a ratio of 14 - 20 is about right for most stocks most of the time. A lower ratio could indicate that investors think this company is in trouble, while a higher one could indicate that the stock has gotten overvalued.
The D/E ratio is a company's debt-to-equity ratio. This is the level of how much debt the company has compared to its total assets. To calculate the D/E ratio, you divide the company's total liabilities by its total assets. For example, a company with $100,000 in liabilities and $1 million in cash and other assets would have a D/E ratio of 0.1.
This number can indicate how potentially risky an investment is overall. A lower D/E ratio is generally considered a safe bet because it means that the company is flush compared with its debts. A high one means that the company has a lot of debt relative to its ability to pay, while a D/E ratio above 1 means that it has more liabilities than it has assets. High D/E ratios (generally anything above a 0.3 - 0.5) might mean a company poised for growth, having borrowed heavily for expansion, but more often they indicate a high-risk investment.