5 things to learn about a company before investing
Whether you're looking at short-term returns or building a long-term portfolio, here are some basic things to learn about a company you're investing in.
Buying shares in a company remains one of the best ways of trying to make money work for you, especially at a time when bank interest rates have slumped to all-time lows. In 2020, more than 10 million individual brokerage accounts were opened in the US alone – a testament to the enduring attractiveness of the stock market for investors.
Before you put money in a business, it's a good idea to get a basic understanding of how the company makes money and whether there are any specific risks associated with its operation.
1. Understand the business
The information can range from what products or services it provides, the markets or countries where it operates, how its major products are doing and whether it is a leader in its industry.
Investors can also consider a simple analysis of the company's strengths, weaknesses, opportunities and threats (SWOT). This will help them work out if the strength of the business lies in its people, its products or its customer base as well as determine the internal and external growth opportunities the company has. This will also help investors come across any current or future threats of industry competition or financial risk from changes in legislation.
A variety of sources can be used for this purpose, including company reports and presentations, regulatory filings, brokerage reports and news articles that highlight recent developments.
2. How has the stock performed?
It only takes a few minutes to review a stock's one-year, three-year and five-year price history, but it is an excellent indicator of a company's performance.
Every stock goes through ups and downs, and historical prices are no guarantee of future results, but a steady upward trend in the share price over a number of years, for example, is generally a good indicator of a growing company that is increasing its revenue.
Looking at the price performance of your chosen company also allows you to answer questions such as how expensive the business is, how many shares will you be able to buy, whether the price volatility matches your risk tolerance, etc.
3. Does it generate adequate profits/dividends?
The ultimate objective of any company is to make a profit and that has a direct impact on its stock price as well. If profits are falling year-on-year, it could be a sign that expenses are increasing too quickly and business operations are inefficient. Conversely, if profits are increasing over time, it indicates that the business is operating efficiently and growing.
Steady or growing profits are a good signal for investors because this enables the company to reward shareholders with returns in the form of dividends.
Steady or increasing dividend payments are often a sign of stability in the company's business. They also indicate a steady and consistent earnings growth, which can be a good bet for the future prospects of the business.
Studying a company's dividend track record also helps the investor find a company that aligns with their investment objectives. For example, some investors may be keen on regular dividend income, while others may be willing to invest in higher-risk businesses that will boost the share price.
4. How is the company's leadership?
Reviewing the management's track record before investing is a good way to determine if there is stability at the top as well as a future growth strategy for the company.
Here are some of the questions that a potential investor should ask. How well is the company managed? What is its general culture? Is it innovative? How well has it handled downturns in the past? How much experience does the top leadership have in this industry? Does it communicate good and bad news honestly?
While there are no specific methods to evaluate a company's leadership, there are certainly some indicators of an effective management team, such as having the management team's compensation tied together with the interests of the shareholders. Other indicators include whether the CEO and top management have continued to serve a profitable company for a number of years and whether the top management's pay is aligned to compensation paid by other companies in the same industries.
These details can be sourced from shareholder presentations, stock exchange filings and company annual reports as well as analyst reports.
5. How do the financials stack up?
While profitability and dividends are a broad gauge of a company's performance, its earnings and debt ratios provide a more in-depth measure, particularly in comparison to peers in the industry.
The price to earnings (P/E) ratio is a good place to start in relation to looking at a company's earnings. It shows how many years it would take for the company's earnings to match the current price of its shares and is worked out by dividing the company's current share price by its earnings per share. The P/E ratio is a key indicator of whether a company's stock is currently over or under priced when compared to the industry average.
While a strong balance sheet is a definite advantage for any company, its ability to pay off any loans is also really important.
The debt to equity (D/E) ratio is a handy metric to gauge a company's debt levels. Essentially, this compares the amount of the loans a company has to its shareholder funds. While typically this ratio is 2:1, it varies significantly depending on the nature of the business and the industry.
A high D/E ratio relative to peers indicates the company has taken on excessive debt to finance its growth and will result in higher interest payments, reducing the amount of money a company returns to shareholders.
Ultimately, being objective is critical when it comes to investing and an analysis based on the above points will help investors remove their personal feelings and look at companies logically.
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How to buy shares
To buy shares in Australia, you'll need to sign up to a share trading platform or full-service broker. Planning on buying US stocks? You'll need to find a US broker, such as such as eToro.
Here is a step-by-step guide to take you through the basics, including how to buy shares online, how much it costs and whether it's a safe option for you.
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