4 things to look for before investing in a stock
- Author Stavros Georgiadis
- Published January 20, 2020
- Word count 889
What are 4 basic things to look for before investing in any stock? The following 4 things are both essential and very important, providing an analytical framework to perform due diligence for safer investments. You cannot control the risk or the potential volatility in the financial markets but applying these 4 things on each stock will provide better risk-adjusted stock picks. And they can help you become pickier in the stock market, as these 4 things have several criteria to take into consideration.
The 4 things to look for before investing in a stock are:
Relative and absolute valuation
Macroeconomic environment, business cycles and sector, industry of the stock
Let’s analyze more these 4 things.
Fundamental analysis. What fundamental analysis does is examining financial ratios to check very important factors which can impact the price of any stock. There are 4 types of financial ratios, and these are profitability, leverage, liquidity and operating or efficiency ratios. These financial ratios combine data from income statement and balance sheet such as revenues and earnings, to determine if the stock is attractive and has also potential for future growth. If you remember that buying a stock makes you an owner of that company even at a very small percentage, then it is prudent to buy fundamentally safe stocks. Stocks of companies that show profitability, have reasonable debt or even zero debt, plenty of liquidity and their management uses efficiently the assets to produce more wealth and added value for the shareholders. At the same time, you should analyze the trend of these financial ratios, look back 3-5 years to check how they have changed. Is net profit margin rising? Is debt increasing? And do not neglect the very strong importance of cash flows, the operating cash flows and the free cash flows. Stocks that show increased cash flows and naturally positive ones should be preferred to others that do not. Would you buy a stock of a company that is very likely to go bankrupt within a short-term period? This precious information can be shown by thorough fundamental analysis. Invest time reading the 10-K, 10-Q reports published by public companies frequently. And keep monitoring the economic news about specific stocks that are of interest to your portfolio.
Relative and absolute valuation. Once you have performed the fundamental analysis of a stock you should check its relative and absolute valuation. A great stock may be overpriced compared to the price observed when it is traded on the stock exchange. You do not want to pay an irrational price. It is better to find undervalued stocks to buy and overvalued to sell short. You can perform relative valuation for any stock comparing popular valuation ratios of any stock such as P/E, P/Sales, P/Cash flow, and P/Book Value with the relative valuation ratios of the whole market, the industry and the sector it belongs to. Again, check the trend of these ratios over time. Is the stock relative undervalued because its recent P/E ratio is at historical low levels for the past 3-5 years? Absolute valuation is much more difficult but there are many financial sites which for a reasonable fee have it ready for you. The risk in absolute valuation is that in any DCF or DDM model very small changes in inputs and assumptions can have a large impact on the fair or intrinsic value of the stock. But it is also prudent to have this absolute valuation in your mind before buying or selling a stock.
Macroeconomic environment, business cycles and sector, industry of the stock. Any company operates within an economic environment at which there are limitations and restrictions or risks. There are two main categories to analyze a stock in a broader financial analysis. The top-down analysis and the bottom-up analysis. The top-down approach in simple words is to look first at how the global economy is performing, then check business sectors and industries, and finally choose the best stocks within specific sectors and industries. Bottom-up approach is the exact opposite. As many analysts have recently expressed concerns about a global slowdown of economic growth in 2019, some sectors which may perform well if the slowdown occurs later in 2019 could be utilities, real estate, health care and consumer staples.
Technical analysis. Finally, timing is crucial for stock investing. Technical analysis can add more value to your fundamental analysis of any stock, providing increased odds to make as much as possible accurate timing buying or selling stocks. Technical analysis is all about probabilities. Under no circumstances it is 100% correct, but if used it can improve the odds of buying a so-called oversold stock with great fundamentals and make a profit. Or sell stocks that appear to be overbought and have poor fundamentals. There are many technical analysis indicators and strategies, but you can start with a very simple such as the crossover and trend of important moving averages such as the 20-period and 50-period moving average in any time frame.
As a conclusion these 4 things can help you perform due diligence analyzing any stock, increasing the odds of selecting equities that meet your criteria and having a reasonable basis to make a profit. Rather than gambling, you will have performed solid financial analysis, which can adjust the risk taken to compensate for a desired and logical rate of return.
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