As a new investor, venturing into the stock market can be a bit intimidating. You know that the idea is to buy stocks at a low price and sell them later for a higher price. But when it comes time to buy individual stocks, you may be at a loss.
How do you go about deciding which stocks to buy and when to buy them? There are several factors you should consider before pulling the trigger.
Factors to Consider When Buying Stocks
When you buy a stock, there are several factors that you should consider before pulling the trigger. After all, you want to buy shares in a great company, at a great price.
But what criteria qualifies a publicly traded company as a great company, and how do you know if the price you’re getting is a great price? How can you tell which stocks are a fit for your portfolio?
Here are the main factors you should consider before buying any stock.
1. Your Time Horizon
The time horizon associated with an investment will play a crucial role in whether it makes sense for your situation. Here’s how time horizons break down:
A short-term time horizon is any investment that you plan on owning for under one year. Investments with a short time horizon have little time for recovery if things go wrong.
If you’re planning on holding an investment for under a year, it’s best to invest in stable blue-chip stocks that pay dividends. The companies represented by these stocks are large corporations with rock-solid balance sheets, making the risk of loss minimal. On the other hand, gains through these investments tend to happen at a slow, steady pace.
A medium-term investment is an investment you intend to hold anywhere from one year and a day to 10 years.
Due to the longer time horizon, you have more time to recover should something go wrong. Although you shouldn’t dabble in penny stocks, even with a medium-term investment, the longer term opens the door to investing in quality emerging markets stocks and other stocks with a moderate level of risk.
Finally, long-term investments are any investment you plan on holding onto for more than 10 years. These investments have the most time to recover if something were to go wrong, giving you the ability to take the most risk in an attempt to generate a significant return.
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2. Your Investment Strategy
Before you even buy your first share of stock, it’s important to study various investing strategies and choose one or more that you’ll follow.
Investment strategies are important because they take much of the emotion and guesswork out of the equation, giving you strict guidelines to follow when it comes to buying and selling stocks. When investing, it’s important to ensure the stocks you buy meet the criteria set forth by your strategy.
There are three key types of strategies used by most successful investors:
- Value Investing. Value investing is the process of investing in stocks that display a clear undervaluation relative to their peers in hopes of generating outsize gains as the market catches onto the opportunity. This is the strategy that made Warren Buffett millions of dollars.
- Growth Investing. Growth investing is the process of finding stocks that have displayed market-beating growth in revenue, earnings, and price appreciation for a length of time. Growth investors believe that these upward trends will continue to outpace the market, creating an opportunity to generate outsize gains.
- Income Investing. Finally, income investors look for quality stocks that are known for paying significant dividends. These dividends generate passive income that can be used to fund one’s lifestyle or reinvested to increase earnings potential.
Before buying a stock, consider the strategy or strategies you’ve chosen and whether the stock you’re interested in fits in well with that strategy.
Diversification is an important part of building and maintaining a quality investment portfolio. This is the process of spreading your investments across various stocks and other securities across various industries and markets.
Before buying a stock, it’s important to consider the level of diversification that already exists within your portfolio.
For example, you may be thinking about buying shares of Apple or Amazon.com, but when reviewing your current investments, you might realize all you have in your portfolio are tech stocks. What happens if the tech sector crashes?
Well, your portfolio focused solely on tech stocks would tank along with the sector.
However, if you consider buying stocks in another category such as utilities or consumer staples instead of adding more tech stocks, should the bottom fall out of the tech sector, the other holdings in your portfolio will provide stability.
4. Share Price and Intrinsic Value
Famous investor Warren Buffett made his billions by comparing the current market price of stocks to their fair market value. When he finds a company that’s trading lower than the company’s stock price should be, he pounces, taking advantage of the discount. Buffett knows that in the majority of cases, an undervalued stock will eventually climb to reach its fair, or intrinsic, value.
This is a process known as value investing, a type of investing that puts the utmost importance on the valuation of a company and uses various metrics to determine whether the valuation is low, high, or where it should be.
Some of the most important metrics include:
- Price-to-Earnings Ratio (P/E Ratio). The P/E ratio compares the price of a stock to the company’s earnings per share (EPS), essentially putting a price on profitability. For example, if a company trading at $10 per share produces EPS of $1 annually, its P/E ratio is 10, suggesting that the share price is 10 times the company’s earnings on an annual basis.
- Price-to-Sales Ratio (P/S Ratio). The P/S ratio compares the price of the stock to the annual sales, or revenue, generated by the company. For example, if a stock trades at $10 per share and generates $5 per share in annual revenue, its P/S ratio is 2.
- Price-to-Book-Value Ratio (P/B Ratio). Finally, the P/B ratio compares the price of the stock to the net value of assets owned by the company, divided by the number of outstanding shares. For example, if a stock trades at $10, has a net asset value (book value) of $1 billion, and has 100 million outstanding shares, it has a P/B ratio of 1.
Before buying a stock, look into various valuation metrics and how they compare to other stocks within the company’s industry. If you’re following the value investing strategy, you’ll want to make sure the stocks you buy are undervalued compared to their peers.
5. Balance Sheet
A company’s balance sheet is an important part of any fundamental analysis effort. It gives you an at-a-glance look at the financial strength and stability of the company.
A company’s balance sheet shows investors the value of assets it owns, the amount of debt it owes, and shareholders’ equity.
When diving into the balance sheet, it’s important to consider the amount of debt the company owes in relation to the assets it owns. After all, as is the case in personal finance, debts can become overwhelmingly burdensome, and in some cases mounting debts can result in bankruptcy.
It’s important to know that the company you’re thinking about buying a piece of comes with a sturdy financial foundation from which to grow.
You’ll also gain valuable information by looking into the company’s cash flow statement. This outlines the cash flowing into and out of the company, showing whether the company has more coming in than it has going out. Of course, you generally want to buy stocks that have more cash coming in than going out, showing further financial strength.
6. The Size of the Company
The size of the company you’re considering investing in plays a major role in the amount of risk you take when you buy it. As a result, it’s important to consider the size of the company in relation to your risk tolerance and time horizon before buying a stock.
The size of publicly traded companies is determined by looking at the company’s market capitalization, or the total market value of the company’s outstanding shares of stock. Here’s how market caps and risk relate to one another:
Penny Stocks and Small-Cap Stocks
Any stock with a total market cap of under $2 billion will fall into the penny stock or small-cap stock category. These companies are relatively young with minimal, if any, profitability. As a result, they represent some of the highest-risk investments.
Mid-cap stocks have a market cap ranging between $2 billion and $10 billion. These companies generally have something going for them. They’ve created a new product, have started generating profits, and in most cases have a promising future ahead. However, they haven’t quite made it big yet.
Mid-cap stocks come with lower risk than penny stocks and small-cap stocks, but there’s still a moderate level of risk, as these companies haven’t attracted the masses quite yet.
Finally, large-cap stocks are stocks representing companies with an overall value of more than $10 billion. These are the companies that have “made it.” In the vast majority of cases, these companies sell popular products and consistently produce significant profits, which are often returned to investors by way of dividends or share buybacks.
As massive companies with huge followings, these companies represent the lowest risk opportunities in the stock market.
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Volatility describes the rate of fluctuations in the price of a stock or other financial asset. The higher the volatility, the faster the stock will rise and fall, while lower volatility assets will move at a slower, steadier pace.
It’s important to remember that volatility describes the rate of fluctuations in price — it doesn’t determine the direction of those movements.
Stocks that experience high levels of volatility will climb dramatically on good days, and fall like a brick on bad days. As a result, these investments come with significantly more risk than stocks that don’t move quite as fast.
After all, if you have a low-volatility stock that moves more slowly and a recent uptrend begins to reverse, you’ll have plenty of time to cash in on your profits before they disappear.
On the other hand, stocks that experience fast-paced movements don’t give you much time to exit the investment when a trend reverses, which could lead to you giving up all the unrealized profits you may have had — or worse, could lead to losses.
8. Dividend History
Dividend stocks known for giving a portion of their profits to their investors by way of dividend payments. While these payments are secondary to value and growth investors, they are nice to receive, and they’re an absolute must for investors following the income investing strategy.
If your goal is to generate income through your investments, it’s important to take the time to look into the dividend history of the company you’re interested in buying.
Ultimately, income investors are looking for high yields, or a high level of income in relation to the stock’s price. Look for a company’s dividend yield (or annual dividend), expressed as a percentage on your favorite stock research platform.
Beyond the yield itself, it’s important to look into the historic dividends paid by the company. Ultimately, you’re looking for growth in dividend payments on an annual basis for a period of three years or longer. A trend of growing dividend payments tells you a few things about a company:
- It’s Financially Secure. Companies can only pay dividends when they have enough cash in the bank to do so. When a company has a strong history of growing dividends, it shows it is financially secure and not likely to fail any time soon.
- It Hasn’t Stretched Itself Too Thin. Some companies will make large, one-time dividend payments, which can act as bait to drive investors in, but keeping those dividends alive would stretch the company’s finances too thin. Companies that offer compelling and increasing dividends consistently have cash to spare.
- It’s Growing. Finally, companies that remain stagnant won’t have the growth in profits required to afford increasing dividends. Companies that pay dividends with a history of steady increases are likely experiencing growth in profitability equal to or greater than the growth in dividend payments.
9. Revenue and Earnings Growth
To make money with stocks, you’ll need to invest in companies that are growing. The best way to determine if a company is growing is by looking at both its revenue and its earnings.
- Revenue. Revenue is the total amount of money the company generates from its operational activities. For example, when Apple sells an iPhone, the sale price of that phone is added to its revenue total.
- Earnings. Earnings is the amount of money a company makes after all expenses have been paid. For example, when Apple sells an iPhone for $1,200, it might pay $500 for manufacturing, $25 for customer acquisition, and $50 for general corporate expenses associated with the sale. In this example, the cost of the phone to the company is $575, leaving $625 left in earnings for the sale of each phone.
It’s important to look at both revenue and earnings because companies can inflate one or the other figure, but will have a hard time inflating both. For example, a company that wants to generate more revenue might spend much more on advertising. As a result, its revenue will grow, but the advertising costs will cut into profitability, leading to shrinking earnings.
On the other hand, if a company wants to inflate its earnings, it may decide to lay off employees or cut back on marketing. While this may increase the company’s earnings for that particular quarter, its revenue will likely decline. Without employees and marketing driving revenue growth, the earnings increase isn’t sustainable because sales will slow.
10. Preferred or Common Stock
There are two different types of stock that companies issue: common stock and preferred stock. The type of stock you buy will play a role in your earnings potential as well as your ability to recuperate losses in the event of a dissolution of the business. Here’s how it works:
Common stock is the standard type of stock that the vast majority of investors buy. If dividends have been declared, these shares are paid dividends and have a claim to the company’s assets in the event of liquidation.
However, their claim to assets is last. Bond holders and preferred stockholders will be paid prior to a common stockholder, meaning that in the event of a liquidation, there’s a strong chance that common stockholders will experience significant losses.
Preferred stock puts the investor one rung up on the ladder. This type of stock generally comes with predetermined dividends that are consistently paid, and will be paid prior to common stock dividends. Moreover, these investors also have a claim to the company’s assets in the event of a liquidation and will be paid prior to common stockholders.
As a result, preferred stock comes with a lower level of risk and generally higher income earning potential. However, preferred stockholders give up their right to vote on important matters. Moreover, these shares are known for slower growth.
11. Debt-to-Equity Ratio
Debt-to-equity ratio is a tool investors use to determine how thin a company has stretched itself in terms of debt. Of course, high levels of debt are bad because bankruptcy becomes a very real possibility when a company is stretched too thin, just as is the case with consumers.
To determine a company’s debt-to-equity ratio, you simply divide the company’s total debts by its total shareholder equity. For example, if a company has $5 million in debt and total shareholder equity of $10 million, its debt-to-equity ratio is 0.5.
The higher this ratio, the more the company has leveraged debt. As an investor, you’ll want to buy stocks in companies that don’t leverage debt too much, meaning you’ll be best served investing in companies with a low debt-to-equity ratio.
Generally, investors look for a debt-to-equity ratio below 1 for the lowest risk investments. Any debt-to-equity ratio above 2 suggests the company has significant debts and the investment comes with a high level of risk.
One of the biggest mistakes new investors make when it comes to investing is blindly buying stocks simply because they know the name of the company or because someone told them to. Unfortunately, actions like these increase your chances of losses and decrease your potential profitability.
If you’re considering buying a stock, it’s important to educate yourself about that stock, the market itself, and the overall economy before pulling the trigger on the purchase. Research is the foundation of any strong investment decision.