Stock investment is increasingly common and easy to do, but it can also be a risky venture. Before you invest in a stock, what are some key things to look at? Here are the top list of questions you should ask before you put in any money to invest:
1) The Business.
Does the company have a viable business that is profitable and likely to be profitable in the future? The way we think about buying stocks is to see ourselves as buying a part of the business, a part of the company. Only if we can see the business doing well do we start to think about buying the stock. When evaluating a business, we should also look at its sustainable competitive advantage, or what Warren Buffett calls the "economic moat". He likes to cite the example of Coca-Cola, which has an enduring competitive advantage, especially in terms of brand name and recognition throughout the world.
2) The Board of Directors and Management.
We should also look at whether the leadership of the company is competent and has a track record of business success. However, in this respect, Warren Buffett thinks that the business is more important than the competence of the management - he rather invests in an excellent business with mediocre management, rather than a poor business with excellent management.
Other than competence, we also have to look at the integrity of the board of directors and management. Are they people of integrity, or is there a possibility that they might defraud the company and its shareholders? Even if no fraud is involved, does the management pursue shareholder-friendly policies (e.g. Has there been a history of share dilutions? Is executive compensation excessive?) Are there corporate governance safeguards in place to ensure that shareholders' interests are well taken care of?
3) The Valuation.
Even if the business is a great one, and the management and board pass muster, the next important question is what the valuation of the company is. For example, the stock market might price the company at a certain price - but we have to ask whether that stock price is reasonable. Only if the stock market is under-valuing the company at a significant margin (what Benjamin Graham calls the "margin of safety") is it wise to invest in the company.
There are a number of ways to value a company - one could use relative valuation or a discounted cash flow valuation. Relative valuation essentially compares certain valuation multiples (e.g. price-to-earnings ratios, price-to-book ratios) of companies comparable to our target company to arrive at an estimate of the valuation of our target company. We could also compare the valuation multiples of our company over time. On the other hand, discounted cash flow valuation essentially forecasts the future cash flows produced by the target company and discounts them to the present to get a value for the company.
4) The Balance Sheet
Another aspect that one can look into is the balance sheet. One of the key things to look at is whether its assets are greater than its liabilities. There are various ratios that we can use to gauge this, including current ratio, debt-t0-equity ratio, quick ratio, etc. The point of this is that we want to ensure that the company can pay off its debts and has sufficient liquidity - i.e. it is not in imminent danger of going into bankruptcy or not being able to pay its debts.
Here are some key questions that one should ask before you invest in a stock. Of course, there are other questions, but these would get you off to a good start. Happy investing!