In this post we will cover 7 Things to Consider Before Buying a Stock. Just wildly buying stocks without taking into consideration why your buying will result in heartburn and a much lighter wallet. Go through each of the below items and you’ll make more sustainable purchases.
- Price/Earnings Ratio
The price/earnings ratio (often shortened to the P/E ratio or the PER) is the ratio of a company’s stock price to the company’s earnings per share. The ratio is used in valuing companies.
- The price/earnings ratio (PER) is used for determining if a stock is ‘the right price’. If the PER is too high that means you will be paying too much for the expected returns. If it is low, the stock may be a deal depending on if it was artificially under valued. This can happen if the share price dropped abruptly but earnings remained fairly stagnant, or if earnings out performed what the market expected. ENB was a personal example of PER for me.
- I had looked at buying ENB back last year but after a bad couple of quarters with under performing earnings the PER rocketed. Since the price didn’t drop as much PER was up above 45. I waited until the price and PER was more in my range in March and grabbed a good position.
- To clarify PER does not indicate(alone) if a stock is a good buy or not. It only shows what the market thinks of the stock at its current earnings. A lower PER indicates that the market thinks that a stock is a bigger risk or isn’t earning enough. However, it also means you will get more earnings for your investment. A higher PER indicates that the market thinks the stock will grow. But it will come at a premium. If you want the stock you can get in but your earnings wont be as high. I always use it when entering into longer term holds. I want a stock that I believe in but has a lower price/PER. Which ties into point 2…
- Belief the Company has a future
If we continue with the ENB example, to see if I wanted stock I looked up the company. Two things stood out to me.
- Enbridge owns and operates oil and natural gas pipelines in North America.
- Enbridge has active projects that must complete and will greatly increase the companies dividends.
For the foreseeable future Enbridge will grow. It has real tangible assets and other companies will have a hard time horning into the market.
In essence what you are looking for is that a company makes sense and will continue to grow. If a company doesn’t have a foundation of value you don’t want to take a risk on it. Flash in the pan stocks are everywhere and if you hitch your wagon to one of those you will watch your investment get eaten up by falling stock prices. This ties into the next point.
- Is the company’s position in market sustainable
Snap is a cautionary tale of a overvalued IPO(Initial Public Offering). People were excited. The next Facebook. A gold mine. The only problem was that Snapchat was neither of those things. If you looked at its place in the market, it wasn’t setup for success. A simple app and an overpriced set of camera sunglasses told the tale of a stock that was overvalued. While it isn’t as bad as others those who bought in at IPO will have lost 2/3 of their initial investment. Always try to identify what niche the company will fill and if it can truly survive there.
- Stock projected versus actual earnings
This concept is pretty simple. You are looking to see if the company is under performing, over performing, or following the market expectations. Below are a few examples of stocks I own for one reason or another.
This is Zynga, a small game developer that has been under performing fairly consistently for the last year. Stock price reflects this. Not much growth(4% at the time of writing this) this year. *edit* large jump in the last couple of days showing 20% growth this year. If you are looking for growth I would stay away from an under performer like Zynga.
Microsoft on the other hand has out performed the markets expectations at every earnings call. This is reflected in the stock price which has grown consistently over the last year up almost 50%.
- Who are the companies competitors
Lets take SNAP as a negative example here. SNAP’s competitors would be companies like Facebook, Google, Apple etc. It was trying to break into a very competitive market with a smaller product that didn’t have a lot of room to grow. These other companies are much more established and can get into a slugging match without blinking an eye. They can go toe to toe with any other company out there and can throw money at R&D. This doesn’t bode well for smaller companies in the same space. You want to find companies that can hold their own against the competition in their market. SNAP was unable to do so.
If the stock is a dividend stock there are number things you should look at.
- How long has the stock been paying out
If it has a history of paying out it is a fairly good sign that it will continue to do so. Dividend Aristocrats are stocks in the S&P 500 that have been increasing dividend payout for the past 25 years. These are all fairly safe bets, especially when you wait for their PER to drop to a level you are happy with. In general the longer a stock has been paying dividends the more likely it will continue so as to maintain its status a dividend giant. A full list of Dividend Aristocrats can be found here.
- What is its dividend yield
This ties into its performance as I talked about in my passive income post, but many times what you will see is the very high dividend paying stocks will not grow as quickly in terms of value. Some stocks such as Ford do not grow at all. I prefer to choose stocks that have a slightly lower dividend yield and show upward growth. This allows you to get gains from both the dividend payment while also accruing value in the stock itself.
If you take all of these things into account you are no longer betting on a unknown. You are taking a calculated risk on your future with an investment.
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