Here is an investing 101 post based on some of my own experiences and lessons learned from being an active stock investor. With the market volatility to continue its even more important now to be careful with which stocks you pick for your portfolio. Here are the 5 key things you should look at to determine whether a stock is worth buying.
1. Quality of earnings and cash flows – This is the “Fundamental analysis” or the hard data/ratios that can be derived from the company financials. Look at the historical performance (annual reports) and future forecasts (analysts). Based on the business conditions and market factors is this realistic? Also, a good track record normally indicates good future performance – all other factors being equal. This may go against conventional theory, but I have seen it too often too ignore.
2. Growth potential – First you need to understand how the company makes its money (revenue) – is it going to grow the revenue streams and how? Also, look at the costs – are these growing less than revenue. Operating margin is a good figure for this. Also, is it an industry where it can acquire other companies or be a target? Look at growth from both an international and domestic perspective. International growth is especially important with the weakening US economy and dollar.
3. Competitor Analysis – Look at the performance of the company’s competitors? You shouldn’t buy if the company is not in the top 2-3 of its industry. Also if the company is dominated by one much larger rival, then this is not a good sign.
4. Quality of company management. Hard for an outsider or non-analyst to determine this. The best thing is to read the company executive profiles on their web sites or annual reports to see their background and skill sets. Also, the best way to judge management effectiveness is to look at how they have grown the company. There are also figures like return on equity (ROE) that can be used as a proxy to judge management effectiveness.
5. Macro Factors – Look at the overall economy and other political factors (this one is important if investing in developing economies). If the overall economy is doing poorly it is unlikely the companies in it are going to do well. However, if the rest of the world is doing well and the company generates most of its revenue overseas then this may be not be such a key factor. The opposite of this logic also applies.
A stock that grades well across all the five points isn’t necessarily a sure thing, but it’s a very good start. There is a lot of detailed analysis you can do under each point, but at least now you have the overall framework.
If you have any more factors to look at, disagree or want to elaborate on the above, feel free to comment. Also, consider there top rated online brokers for the cheapest and fastest stock trades.
Good luck investing