Buying a single stock is risky. You are, in effect, investing in a company and betting your money that the company will be profitable and that your investment will pay off in the form of dividends or an increase in the share price that you take advantage of by selling the stock at some point.
Mutual funds and ETFs that track many stocks are much safer. But you already know that and are reading this because you are interested in learning more about the process of choosing a stock.
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Why Do This?
Aside from learning how the market works and satisfying your curiosity, buying individual stocks can be profitable – as well as risky. You have already have a diversified portfolio of mutual funds and ETFs and want to add a few individual stocks.
As an individual stock owner, you can save money compared to someone who pays a fund manager (through expense ratio). You are also more directly becoming part owner in the company.
Basic RulesSome of the best rules to follow are also common-sense rules.
Buy what you know. Invest in an industry that is familiar to you. It could be a restaurant chain, apparel maker or a well-known company that’s easy to research online.
Avoid hype. Combined with buying what you know avoid buying something just because it is in the news. If you don’t understand something about the business, you won’t know if a company has any standing.
Price and valuation. You should be looking for stocks are “undervalued.” This means for whatever reason they are selling for less than they are worth. This is expressed in the stock’s price-to-earnings ratio or P/E. P/E below 15 is considered cheap and above 20 expensive.
Compare apples to apples. When comparing stocks compare stocks of companies in the same sector that produce similar types of products. If a company is cheaper than its peers, it might be a bargain (or a dud). That’s part of the beauty of the market.
Check the company out. This is where you tear into company financial reports. Public companies must release information quarterly and annually. There are Widgets on FinanceBoards that include this information and save you the trouble of digging it up.
Look for growth. Specifically, you are interested in revenue growth. Is the company showing growth over the long run? That’s good. Day to day or even week to week is less important.
Consider profit. When you subtract expenses from revenue, the amount left over is profit. To grow profit, a company must increase revenue while controlling costs.
Debt matters. The company’s balance sheet will tell you how much debt (borrowed money) the company has. Too much debt can be bad because income must pay interest and debt payments and can’t be given to shareholders.
Look for a dividend. A dividend is a cash payment to stock investors. Some companies pay regular dividends, some do not. Dividends are generally an indication the company is healthy.
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No Magic Bullet
Picking a stock is more art than science. So many factors affect a company’s health, it’s impossible to choose one or two and use them alone. Some financial information is easy to track down. Some kinds of information – such as popularity, leadership style, competitive advantage, reputation are not.
At the end of the day, picking a stock is a matter of guessing. The more you learn about a company, the better you will become at picking. Your own personal risk tolerance will help drive you toward stocks that are more volatile or more dependable.
Next: The Nitty Gritty