Determining if a company’s stock is worth adding to your portfolio may seem daunting. It doesn’t have to be. You may be looking to create a more balanced portfolio. You may want to invest in specific types of companies. You may be investing for the first time and need to know what companies to invest in first.
Regardless of why you are looking to invest, you should thoroughly research a company to determine if that company fits the criteria you want. Correct research on a company will aid you in deciding whether the company is worth investing in.
After all, the objective is to minimize the risk with the highest potential rate of return.
In this guide, I have put together a plan to help you determine if you should invest in a company’s stock so you can start evaluating individual companies and determine if a company is worth investing in.
Disclaimer: Every stock you purchase comes with a risk. But there are steps you can take to minimize those risks. Only invest in what you are okay with losing.
- What are the company’s products or services offered?
- Are the products or services in high demand and of high quality?
- Is the industry doing well?
- How has the company performed in the past?
- Are talented, experienced leaders in charge?
- Are operating costs low or high?
- Is the company in heavy debt?
- Is the stock worth the current price?
- Does the company pay dividends?
What are the company’s products or services offered?
When researching a company and its stocks, one must understand what products or services the company sells.
Does this company sell high-demand products or services that provide a safer investment? Is the company selling a product or service that is more risky but innovative to society for a potentially higher rate of return? Does the company sell a specific product or service that you directly support or have used?
You shouldn’t invest in a company you do not believe has long-term value. As Warren Buffet stated, don’t buy a stock because you think the price will increase. Invest in companies you understand and feel will provide long-term value through the products or services offered.
It’s impossible to predict what the market will do. That is why you want to invest in companies you believe have long-term value. You are buying into that company’s future. As Peter Lynch says, “invest in what you know.”
This same concept also applies to ETFs, mutual funds, and index funds because you are investing in a specific sector or group of companies. For example, if you invest in the S&P 500, you believe that the top fortune 500 companies will continue to grow in the long term.
Familiarity with a company allows you to understand better the market and the environment the company is in to make educated decisions. Before you do invest in a company’s stocks, there are additional steps below that you must take to determine if you should truly invest in that company.
Are the products or services in high demand and of high quality?
Just because you like or believe in a company’s products or services doesn’t mean you should automatically invest in them. The Harvard Business Review has a great article called Quality Is More Than Making a Good Product.
Not only do you want a high-quality product, but you also want a product in high demand. A theory known as the Law of Supply and Demand suggests that demand will decrease when prices and supply rise.
There are outside factors that can cause increases or decreases in demand for products or services, such as:
- Availability of substitute products.
- The number of consumers.
- Change in consumer tastes or preferences.
- Elasticity vs. inelasticity.
- Consumer income.
- Consumer expectations.
Is the industry doing well?
Revisiting the previous section a bit further, is the industry the company you are interested in investing in also doing well? A declining industry likely means declining sales and revenue. Therefore, a company’s long-term outlook in that specific industry would be a costly investment.
An example of a declining industry is data recovery services. Thanks to cloud computing, computer files that are damaged, corrupted, inaccessible, etc., no longer need a data recovery service company to recover data. Instead, businesses are leaning towards cloud computing.
According to IBM, cloud computing gives businesses access to applications, servers, data storage, and development tools when requested. Cloud servers are hosted at a remote data center and managed by a cloud services provider (CSP). A CSP company is an excellent example of a potential company you can invest in, as the industry is expected to grow 15.7% through 2030.
How has the company performed in the past?
Another vital part to help determine if you should invest in a company’s stock is understanding how the company has performed historically.
Many investors begin their research on a company by reviewing annual returns. However, be careful when doing so. Reviewing current year-to-date (YTD) returns is not accurate enough to form a decision because it needs a longer timeframe.
Look for things such as:
- 5-year average annual return.
- How the stock compares to the competition.
- How the stock has performed in the overall market.
While reviewing the company’s financials, Investopedia has a great article explaining how to do so.
More experienced investors may use a fundamental and technical analysis approach. I will have a detailed article regarding these two specific investment strategies soon.
Both strategies have their strengths based on personal preference. Neither approach is superior to the other.
There are many other strategies you can also use to review a company’s past stock performance, such as:
- Balance sheets
- Income statements
- Cash flow statements
- Price-to-earnings ratio (P/E)
- Price-to-sales ratio (P/S)
- Earnings per share (EPS)
- Return on equity (ROE)
- Debt-to-equity ratio (D/E)
- Debt-to-asset ratio (D/A)
Regardless of the methods you choose to evaluate a company’s history and its stock performance, you must take the time to review the past. It gives you the most accurate representation of whether you should invest in the company’s stock.
Are talented, experienced leaders in charge?
Investing in a company with outstanding leadership can be rewarding long term. Exceptional leaders are generally shown to generate above-market returns in the past. That’s because companies with strong leadership are typically leading their respective industries.
Vision, team building, and structure are critical components of a company’s long-term success.
Are operating costs low or high?
What did the income statement reveal about the company’s costs? Are the operating costs still too high?
There is a reason an investor reviews the return on equity, free cash flow (FCF), price-to-earnings ratios, and operating leverage of a company. According to Investopedia, reviewing these things can help gauge investors on a company’s well-being and risk levels.
You are measuring a company’s fixed costs as a percentage of its total costs to evaluate the breakeven point of a business.
High operating leverage means most of the company’s costs are fixed costs. Companies tend to earn more significant profits from sales. But volume must be maintained or exceed those costs for success.
Low operating leverage means most of the costs vary. Each sale yields a smaller profit but only needs a small volume to cover their fixed costs.
Is the company in heavy debt?
Outside of profit and operating costs, how much debt does the company have? Heavy debt sometimes means you shouldn’t invest in that company. It usually entails a higher risk but a possible buy-low opportunity if you are willing to take that risk.
The most prominent example of this is Warner Bros Discovery Inc (WBD).
WBD currently has a staggering $50 billion in debt. That is a scary balance sheet to review. The WBD debt situation goes well beyond just being in heavy debt. Issues such as negative free cash flow and elevated costs create a complicated situation for the company.
The positives of why you could invest in WBD with such heavy debt is the pending launch of a new streamer service that will combine HBO & Discovery+. Also, the current price of the stock is still incredibly cheap.
If choosing to invest in a company like WBD, you are playing the long and patient game.
Is the stock worth the current price?
As you get closer to determining if a company is worth investing in, you must investigate the current stock price and determine if the time to buy is now.
Does the stock look undervalued? Using the P/E strategy can be excellent for determining if the current price is worth the buy.
Another idea is setting a target price for which to buy/sell a company’s stock. Apps like Fidelity allow you to set notifications for individual stocks if it reaches a specific price based on the filters you put in.
That way, you can take advantage of your window to buy or sell by having to watch the markets all day long. Most of us work full-time and cannot invest every minute of the day watching the stock market.
Does the company pay dividends?
The final element to consider before deciding to purchase a company’s stock is whether the company pays dividends or not. Dividend investing is a prevalent method of investing. You can live off dividends if you invest enough money in dividend stocks.
Being a shareholder of a dividend stock means you get paid a portion of the company’s profits. Early on, you can increase your investments by reinvesting the dividend payouts into that company.
While dividend stocks can be a significant part of your portfolio, some risks are involved. That is why you should follow the steps above to invest in company stocks that you determine are worth the investment.