5 questions to ask before you invest in a company

Tips

28 Feb 2017

There are a lot reasons why you might decide to invest in a company.  You’re a big fan of the company’s products. You admire the CEO. You’ve read a positive news story.  Your friend swears by the stock. 

Unfortunately, none of these things have any bearing on whether this particular stock is a good buy. The question you should be asking is: “Is this stock currently under-priced?”


Intuition is not your friend in online trading

As a self-directed investor, it’s important to accept that there is no short cut to answering this question. Intuition probably serves you well in many areas of your life. But stock picking for your online trading isn’t one of them.

As a professional, you’ve probably backed your hunches with great success. But when you trust your instincts at work, you’re relying on ‘expert intuition’ – the instant recognition that something is ‘right’ or ‘wrong’ based on years of experience.

There’s no such thing as ‘expert intuition’ for company shares for two reasons. First because there’s too much uncertainty. As we’ve seen time and again in world markets, ‘unexpected’ is the new normal. Even if you’ve been trading shares for decades, the market can still act in ways you’ve never seen before.

Second, there are too many factors involved in deciding whether a stock is a good buy. You need to look at the top down factors: What’s the economy doing as a whole?  What does that mean for this company’s industry? And you also need to look bottom up: Is the company financially sound? Is it competitive within its industry?


Fortune favours the researcher

This means there’s no substitute for research. You need to understand how a company makes money, its strengths and weaknesses, where it’s going next and the environment it’s operating in. 

The good news is most of this information is readily available on your online trading platform. You just need to know what to look for and where to find it.


Where to start looking

Check your online trading platform for broker consensus recommendations. These are collated from broking and research houses.  Basically, they tell you that four to five expert sources think a particular stock is a good buy.

That doesn’t mean you should buy it. These recommendations don’t come with an explanation but they can point you in useful directions to start digging through the company information provided by Morningstar on the online trading platform.

Online trading is a great way to get started in investing. But if you're not sure, check in with an expert.

Morningstar offers objective company data. If you’re interested in ASX announcements or alerts from the Dow Jones newswire – they’re all here.

You can search through all this information to find indicators that a company you’re interested in may be undervalued.

Here are five questions to help you find some of those indicators:

  1. Is this company financially sound?

    No single metric will help you evaluate a stock. At the very least, you need to consider:

    1. Profitability – don’t just rely on the dollar figure for annual profits. Make sure you also take a look at ‘net margin’ – the ratio of profits to revenues – and compare it to peers. A relatively higher net margin means this company could be in a better position than its competitors to grow and expand.

    2. Operating efficiency – ‘operating margin’ can give you an idea of how good management is at controlling costs.

    3. Solvency – a low ‘debt-to-equity’ ratio can indicate both sustainability and investor confidence.

    4. Liquidity – a negative ‘working capital ratio’ may indicate a company cannot cover its debts in the short term. In the long term, a declining ratio (even if it’s positive) could be a red flag that you should look further into this stock before buying it.

      You’ll find explanations of these metrics on your online trading platform. Make sure you consider them in context. A metric that looks terrible in one industry may be normal in another. In some industries, margins are perpetually on a knife edge.

  2. Who runs the company?

    The company’s website will tell you about the background and experience of senior managers, including their tenure with the company. A quick search of industry media will tell you what they’ve done before and whether they’re respected.

  3. What is its earning outlook?

    In addition to the company’s own full and half year forecasts, take a look at its earnings history. Does it have a history of steady earnings growth – or are earnings volatile?

  4. Is it over valued?

    Have a look at the price-to-earnings multiples. They’re not a perfect gauge, but you need to consider how much you’re paying for this stock.

  5. Who are its competitors?

    How does it stack up against them? Is it taking market share? Is the market vulnerable to digital entrants?

Self-directed online trading is a great way to get started in investing. But don’t discount the value of a financial adviser. If you’re not sure about the research you’ve unearthed, check in with an expert.

Ready to start trading? Open an online trading account now or call 1800 013 034 for more information. 

Looking for investing advice? Request a call for a no obligation free chat with one of our experts.

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