This article is part two of a three part series in which we already explored the questions you need to ask yourself to ensure you are ready to invest in the stock market, we will now tackle how to evaluate a potential stock pick (this article), and finally how to set up an online account to buy stocks.
So you’ve checked off all of the prerequisites to get yourself ready to invest in the stock market:
- You’ve paid off all of your high interest debt such as your credit cards.
- You have 3 months worth of living expenses in cash stored in an easily accessible savings account as a safety net in case of an emergency.
- You’re actively investing in your company’s 401(k) or similar program and taking advantage of the full company match.
- You’re reading this (and hopefully many other!) articles to learn more about the research you need to do on each company or mutual fund in which you intend to invest.
- You understand you are buying an actual piece of a company, not just a piece of paper. As such, you have carefully considered the risks of investing in stocks and the various ways to mitigate them.
Very sensible. Well done!
Now let’s cover some simple, common sense ways to evaluate a company and their stock price.
Disclaimer: I am not a financial expert, advisor, or even an analyst by any stretch of the imagination and these are my opinions. However, I’ve watched, read, and listened to enough of them to know the basic questions to ask myself when considering a stock or mutual fund to buy. Furthermore, due to my age and risk tolerance, I am able to invest in stocks for the long haul, thereby giving them time to really appreciate and reducing the risk of a mistake or market decline affecting my retirement plans. Invest sensibly.
How I Evaluate Stocks:
- Do I know how this company makes money (revenue)?
- What is the market potential of the various revenue streams?
- For example, you could search for the “number of people who play video games” and compare that number with the monthly active users of a video game company such as Activision Blizzard. If there is a lot of room to grow, you can have a bit more confidence in the longevity of the company’s various video games.
- Have I personally used the product or service?
- Where is this company located?
- Have I considered and researched the top three competitors of this company?
- Where does this industry fall on the Gartner Innovation Hype Cycle?
- For example, does the company make virtual reality headsets or fax machines?
- What does the future of the industry that this company operates in look like?
- What regulatory headwinds or tailwinds might affect this industry?
- For example, there is a government mandate for vehicles to be more fuel-efficient over time. Does this sound good or bad for an oil company long term?
- Has the company been able to increase their revenue year over year or has it fallen?
- Has the company been able to pay down their debts (called liabilities) year over year or has their debt slowly increased?
- Relatedly, does the company have enough short term assets (cash) to cover their short term liabilities (debt)? If not, it may signal that the company is at risk of going bankrupt.
- How much cash does the company have on hand? How has it trended?
- Does the company pay dividends, buy back their own shares, or does it reinvest profits in acquisitions and Research & Development?
As I mentioned in my previous post Are You Ready to Invest In the Stock Market? (5 Questions to Ask Yourself), Yahoo! Finance is a great place to research companies. You can view company profiles, financial history, as well as analyst opinions and news articles about the company all in one place.
Another awesome resource is the company’s own investor calls. The app Earnings Calls gets recordings of all publicly-traded companies and loads them into their app for easy listening. Definitely listen for the questions investors ask management of the company towards the middle and end of the calls.
- Have expenses of running the business been rising or falling in tandem with revenue increases/decreases?
- If a company can make more money with the same amount of people or equipment, their margin goes up, more generally referred to as “profitability“.
- What is the price to earnings ratio for this business and their competitors?
- How volatile is the stock? Can I trust myself to ride out the bumps?
- Beta is a common measurement of volatility. More than 1 is considered more volatile while a beta of less than 1 is considered less volatile. Penny stocks are often more volatile than shares of large, well-established companies. It’s not uncommon to refer to buying penny stocks as speculating rather than investing. But you never know, there could be gold in dem der hills!
My Own Portfolio
- Am I diversified enough after this purchase?
- How many stocks do I want to own? More than 30 is probably overkill.
- Is this company considered small, mid, or large cap? Growth or value? What is the rest of my portfolio considered?
- Are all of my investments in one specific country or region?
- Does my portfolio have enough cash? Check out this post to increase your cash savings:
How I Evaluate Mutual Funds:
A “mutual fund” is a fancy way of describing a pool of money from many investors (like you and I) collected by a financial institution and allocated to a specific set of investments such as stocks, bonds, or real estate. This is a great option to reduce the risk of being invested in a single company. Furthermore, a mutual fund may allow you to own fractions of shares of high-priced companies. Some online brokers now allow this as well even when buying stocks with is great.
If yours doesn’t, you may not be able to invest in Amazon due to their high share price. However, by investing in a mutual fund, you can own a fraction of a whole share of Amazon. One downside to new investors choosing mutual funds is they can sometimes have a high initial investment requirement.
However, most importantly when evaluating a mutual fund, is to consider the annual fees (expense ratio) of the fund. Aim for less than 1% as an expense ratio, and preferably less than 0.50%.
Do yourself a HUGE favor and watch this hilarious and informative 20 minute episode of “Retirement Plans: Last Week Tonight with John Oliver (HBO)” for an explanation on why expenses on your mutual funds and 401(k) funds are so critically important to your lifetime returns:
- What are the top companies and holdings of the fund?
- What is the expense ratio of the fund?
- How much money does the fund oversee collectively?
- Who manages the fund and how long have they been doing so?
- How has the fund performed over 1, 5, and 10 years?
- Does the fund focus on tracking the general market, or is it industry or target date specific?
- How has the fund performed compared to similar funds or the market in general?
- What is the expense ratio of the fund? (This is listed twice on purpose!)
- Does each purchase of the fund have a small set fee? (called commissions or transaction fees)
- What is the minimum initial investment amount I need to start?
- What is the minimum recurring investment amount I need to make to add to my fund?
- Does the fund shift investments over time? You will commonly find this approach in “Target-Date” funds which automatically shift from stocks to bonds and other lower risk assets as you near retirement age.
Did I mention to check the expense ratio? (Okay I’m done.)
How to Evaluate Index Funds:
Index funds are really similar to mutual funds but they are less actively managed by financial professionals so they have less expenses (remember John Oliver’s video?). Index funds seek to replicate the overall companies and weights which make up the index you’ve chosen. So if you buy shares of an S&P500 index funds, your returns will likely mirror that of the S&P500.
- What index does the fund track?
- What is the expense ratio of the fund?
- Does each purchase of the fund have a fee? (called commissions or transaction fees)
There you have a basic set of general questions and information to get started on your research.
I recommend watching YouTube videos, listening to podcasts, and searching for different ways to evaluate a stock using in depth quantitative analysis. (I failed calculus so I stick with the basics.) These tips and questions should be more than enough to get you started.
Please don’t skip the research. You are investing, not gambling.
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