Before investing in any stock, go to their corporate website, look for their investor relations section with SEC filings, and download their latest 10K or Annual Report. Every publicly traded company is required to file certain documents with the Security and Exchange Commission (SEC), in order to remain in compliance and keep trading publicly. You can also find company filings at the SEC's website. Type in the ticker symbol right on the SEC homepage, and access all their public filings.
Read through the 10K, their annual and most in-depth company filing, paying particular attention to the Management's Discussion and Analysis (MD&A). Understand all the different businesses and segments of the company, and how they contribute to the top-line (revenue) and profitability of the business.
How profitable is the business?
Once you understand how a company makes its revenue, you next want to understand how much of that revenue makes its way down to its stakeholders. There are a few different measures of profitability to consider.
Gross profit is what is left of revenue after cost of goods sold. What does it cost to produce the goods being sold or the services being provided? Revenue less cost of goods sold or cost of services is gross profit. Gross profit divided by revenue is the gross margin. Some businesses have very high gross margins, like software companies, where the cost of producing one more good is very little. Other businesses have very thin gross margins, like grocery stores, where the cost of goods sold is very high relative to revenue.
Operating income is what is left after reducing gross profit by all the other costs of sales and general administrative costs. This can be everything from marketing to salaries for executives. You may hear operating income referred to as EBIT, or earnings before interest, which gets paid to debt holders, and taxes. Operating income divided by revenue is the operating margin.
Understanding whether your stock is a high or low margin business, the cost drivers, and how much is left for shareholders (net income or earnings) is important to understand what you own.
How fast is the company growing?
The annual and quarterly earnings reports, filed with the SEC as a 10K and 10Q, respectively, report historical company performance. Reviewing these statements over time will help you form a picture that tells you how fast a company has been growing historically, and help you determine how fast they may grow in the future. Look at the historical trends and review the MD&A to understand what the company management is telling you about growth going forward.
Growth is a percentage calculated by taking the current year divided by the previous year and subtracting 1. You can use this to calculate revenue growth, operating income growth, and earnings growth.
What is the company's capital structure?
Capital structure is the way a company is financed. Just like you may take out a mortgage to purchase your home, companies may take out debt to fund growth, acquisitions of other companies or assets, and even general operations. A company's capital structure is just understanding how much of the company is funded by equity vs. debt. Equity is typically calculated as the market value of the equity (share price times the total shares outstanding), while total debt is reported on the company's balance sheet.
When looking at a company's total debt, it is important to assess whether it is generating enough earnings to support the debt. EBIT (earnings before interest and taxes) vs. interest expense is one measure. EBITDA, EBIT plus the non-cash costs of depreciation and amortization of assets, vs. interest expense is another measure. Debt to EBITDA is a common measure of leverage.
Finally, free cash flow is a good measure to assess how much cash a company is generating for shareholders, to be paid as dividends or to pay down debt, or for future investment back into the company. Free cash flow is can be found by looking for the company's cash flow statement and deducting capital expenditures from operating cash flow.
Too much debt can put an entire company, and all the shareholder's equity, at risk. Inadequate free cash flow leaves no money for shareholders or reinvestment in the company for future growth and may require the company to take on more debt going forward.
Does the company pay a dividend?
Some (but not all) companies pay shareholders a small amount every quarter. This is known as a stock dividend. This is additive to the return you earn on your stock beyond just increases in the share price.
If your company pays a dividend, how much is it annually? The annual dividend divided by the share price is known as the dividend yield.
What is the valuation ratio(s)?
A stock's share price is meaningless. What?!?! All the financial news talks about all day long are how the share price moves up or down, and the specific price of the market index. But whether a stock price is $8 or $800 actually tells you very little about the stock itself, the size of the company, it's revenue or earnings, or if it is cheap or expensive.
If you go to the store to buy a bag of flour, and I tell you one is $2 and one is $10, which one would you buy? How do you know if it's cheap or expensive? What else would you need to know to make a good purchase decision? What is more valuable to know is the price per pound, or how many pounds are in each bag.
Stock prices are similar. What matters more than the share price is the share price relative to specific company metrics, also known as valuation ratios. The most commonly examined ratio is the P/E ratio, or Price to Earnings. Because the price is a per share metric, we compare it to a per-share earnings metric or Earnings Per Share. We can look at it on a trailing or historical basis, as well as on a forward-looking basis, comparing price to earnings estimates.
On average, the S&P 500 trades, or is valued at about 16-18x forward earnings estimates, and 20-22x trailing reported earnings. A reasonable rule of thumb? Stocks should trade at a P/E ratio equivalent to their earnings growth rate, or a PEG (price to earnings growth) ratio of 1. Knowing your stock's valuation ratio relative to the market, its industry and competitors can indicate whether your stock is cheap or expensive. It could also be an indication your stock is growing earnings faster (higher ratio) or slower (lower ratio) than the market.
What is the current news saying about the company?
There are entire funds dedicated to investing in event-driven return strategies. They buy stocks when 'something' is expected to happen. Reading the recent news on a company and its industry will give you an indication if there is consolidation activity occurring, or if there are investigations or lawsuits pending. Maybe the company is working on bringing a new product to market that will boost growth going forward.
All of these factors: merger and acquisition activity, pending litigation, patent awards, FDA approvals for biotech companies, even changes in government legislation can have an impact on your company's future earnings, and therefore the future share price.
How does the company compare to its industry, competitors and the market?
Once you have looked at all of the above factors for a specific stock, you then need to compare them to their competitors, other company's in their industry and the market as a whole. This will give you a greater understanding of how the company is performing relative to its industry and the market. It will help you determine whether your stock is cheap (low valuation ratios vs. industry or market) or expensive (high valuation ratios vs. industry or market).
You then have to decide if their valuation is justified.
Is it a good investment?
It is critical to remember that when investing in stocks, returns are not guaranteed. But armed with all of the above information, you can now make two critical evaluations that strongly tilt the odds of good returns in your favor:
- Is this a great business?
- Is it trading at a good price?
Great businesses are those you can invest in if not forever, at least for years or decades, without worrying if they will still be in business tomorrow. They are industry leaders with great market share. They have competitive advantages that make it difficult for others to enter the market and erode their growth and profitability. And they are led by trustworthy and proven management teams. If a company isn't a great business, it may not be worth buying at ANY price.
Understanding their profitability relative to their current share price, and their valuation relative to the market and their competitors will help you decide whether now is the right time to buy that great company. Buying great companies at a discounted or below average valuation is the key to value investing, and long-run returns that exceed the market. Buying at a discount protects your downside in market downturns, providing you with a margin of safety.
Looking for a more formal way to collect and track all you need to know about a company before you buy it? Download the Investing in Stocks 101 spreadsheet from the FREE Family Finance Mom library. This is a great template you can use to analyze any company before you invest in it.
Download your 10 Things to Know About A Stock (Before You Buy One) spreadsheet above. Follow the cues in the spreadsheet to complete the analysis of your specific stock. Data you need to fill in appears in pink text. Everything in black is calculated for you.
I won't lie to you - investing in individual stocks is a lot of work, if done well. Sure, anyone can just buy a stock because they like the business, but buying individual stocks without being informed is really no better than throwing darts at a dartboard and hoping to hit a bullseye. To have a well-diversified portfolio and limit individual company risk, you need at least 10-12 different stocks in your portfolio... that means doing all this work 10-12 times, and know that not every company you do all the work on will meet your great company, fair price criteria. You also need to monitor all your investments for ongoing performance, news and any business changes.
If that sounds like more work than you can handle or are prepared to do, investing in individual stocks may not be the right choice for you. There are other ways to gain equity market exposure without investing in individual stocks. Be sure to follow me on Instagram for my weekly LIVE sessions to learn more about Investing for your family's future and freedom. You can find this post and more about investing on my Investing 101 board on Pinterest.
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