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Researching stocks can be overwhelming. There's so much information available that you may not know how to get started or where you should focus your attention. This step-by-step guide on how to research stocks will help you understand what matters—and what doesn’t.
Doing research on stocks is much like doing research on a new dishwasher. Only instead of considering colors and whether or not it sounds like an airplane taking off, you're considering how the company is doing financially, if they have strong leadership in place, how their values align with yours, how they make money, and the future projects they have under way. Here's an approach that ensures you fully understand the stock you want to invest in.
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Determine how much you're going to invest
Before you do any research on stocks, decide how much you want to invest. One investment strategy is to choose a low-fee, diversified mix of assets like robo-advisors. You could pick individual stocks, but that's a practice that's notoriously risky. If you plan to select stocks yourself and make trades, be warned that you could end up losing everything.
Once you have your core investment strategy in place—and have money left over you don’t mind risking—you may want to invest in stocks. Before you get started, note that investing in stocks should represent a small portion of your overall portfolio—because of the inherent risk associated with tying a lot of money to the fate of a single company.
Decide what you're going to invest in
The next step is to figure out where you want to put your money. Do you want to invest in an industry such as renewable energy? Or would you rather buy stocks in a specific company such as GM Financial or Apple?
Investing in an Exchange Traded Fund (ETF) is one way of achieving diversification. An ETF represents shares from many companies in an industry, spreading the risk and diversifying your investment.
If you’d rather invest in individual companies, however, here’s what you need to consider before buying a company’s stock:
Examine company reports
Publicly traded companies are required to publish reports with information about earnings, net income, and so on. Most companies will have these reports available on their websites.
Look for a section targeted at investors and review those pages for the most recent information. If you have difficulty finding the reports, check EDGAR, which is the U.S. Securities and Exchange Commission’s (SEC) filing database. For reports and documents filed with the Canadian Securities Administrators, check SEDAR, which is short for the System for Electronic Document Analysis and Retrieval.
A company’s reports will tell you how they make money, what risks the business is facing, and the company’s trajectory. Each company may offer several reports for investors to review. Start with the company’s 10-K filing, which is filed annually with the SEC. An independent third party audits the information in this report, which goes back five years.
This comprehensive report will give you an overview of how the company earns money, any issues with management, and current and potential risk factors.
When reviewing the report, here’s what you should consider:
Income Sources: It’s important to understand how the company makes money. Read the management discussion section and analysis to get an overview of income sources.* *
Company Risks: Every company faces risks. The company reports will have a section about the risks for the company and the industry. Also, try to consider potential risks the report doesn’t mention.
Company Trajectory: Review the company’s historical revenues and cash flow. What part of the business is the company investing in? Where is it putting its money in terms of growth? Figure out how they are getting the cash flow and how well it's paid off so far. Review projected payoffs for current and future projects.
Review the financials
Company financials are an important part of the picture. The best place to find this information is the company’s 10-K report, because an independent third party audits the data. The report includes financial data for the past five years and can help you spot trends.
Here are three numbers you should review:
Net income: A company’s net income is an important measure for its profitability. It includes the company’s revenue minus expenses, depreciation, taxes, interest, and so on. It shows if the company had a gain or a loss at the end of the year (or a quarter).
Price-to-earnings (P/E) ratio: This number measures a company’s current share prices against its per-share earnings. The ratio is often calculated using historical data, but it can show future performance. Compare the company’s P/E ratio to others in the industry to determine how it stacks up against the competition.
Return on equity: To calculate a company’s return on equity, divide the net income by the shareholders' equity. This number is important because it shows if the company is using investors’ money effectively to increase profits.
Understand the company’s industry
Before investing in a company’s stock, you need to understand the industry. Is the industry growing or shrinking? Is there anything disrupting it? Consider what opportunities the company has for making money in the industry.
Research the company’s main competitors and how they stack up. Are they better funded? Do they offer a superior product or a lower price point? Consider if the competitors have more talent on their side or other advantages such as patents that give them an edge.
Look at the company's leadership
Without strong leadership at the helm, many companies cannot function well. It’s important to research the leadership team and their plans for the company.
Investigate beyond just the names and basic bios on the company’s website or in reports. Research each member of the leadership team to find out more about their background, management style, and past issues.
Keep an eye for red flags that may not be clear outright. Past troubles for any of the executive officers may signal a rocky future for the company. Make sure you’re comfortable with the company’s management before investing your money in it.
Check how the company's values align with yours
Review the company's mission statement, business practices, and history. Consider what position the company has on current issues in their industry.
Besides the company’s website and materials, read news reports about the company's senior leadership. Do their actions align with the company's public image? How do they handle a crisis? You can learn a lot about a company based on their actions in times of stress.
When you invest in a company’s stock, you’re voting to support its current and past actions. Make sure you’re comfortable supporting a company’s actions before buying a single share of its stock.
Read expert opinions
As part of your research, you can also review expert opinions about the company and the industry. If you do, keep in mind that many analysts are behind the trend and tend to focus on keeping management happy rather than on providing a good analysis.
Don’t use this as your main research strategy, but it can help you fill in knowledge gaps. Take any expert analysis with a grain of salt and do additional research to make sure you have the full picture.
Final thoughts on researching stocks
Before you consider investing in individual stocks, cover your basics with a diversified portfolio, which will produce consistent returns over the long run. If you have leftover money, you can consider investing in individual stocks.
Proceed with caution as you are just as likely to lose your investment as you are to come out ahead. Research each company and industry before buying stocks with your hard-earned dollars.
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