INVESTING

What to Know Before You Buy a Stock - Stock Buying Basics

Most investors are in it for the long term. Most investment decisions are not made on the spur of the moment. They require detailed research and answers. After all, the more you know, the better your choices. What kind of research should you do? What are the stock buying basics?

At a minimum, you should be able to answer the following questions:

What does the company do?

This sounds like a no-brainer, but you would be surprised at how many people purchase stocks based on someone's recommendation or hot tip without even knowing what they are buying.

Not only should you know and understand what they do, but where they are at in their growth cycle. Are they a new start up, a company with 10 to 15 years of solid growth, or a tried and true institution that's been in business for over 75?

Knowing this will help you classify the stock as either a growth or value stock.

How much are they selling?

Take a look at their sales/revenue figures. Do they generate the sales to validate their stock price? If they don't, then chances are you're buying into marketing hype which will end in unnecessary risk taking. If you have a very low tolerance for risk consider buying companies with sales totaling over $1 billion of which there are more than 1400.

Are they profitable?

Two basic things you need to check are the Return on Equity (ROE) and the Return on Assets (ROA). ROE is the ratio of a company's twelve-month net income to its shareholders equity. It's used frequently, but is flawed. If all things are equal, high debt companies will typically have higher ROEs than low debt companies.

So if you used only this calculation, you would end up with a portfolio weighted heavily in high-debt stocks. Therefore, it is also important to look at the ROA, which is net income divided by assets and includes liabilities.

If all else is equal, the lower the debt, the higher the ROA. A good rule of thumb is to look for companies with ROAs above10% and avoid ones at 5% or lower.

How much debt are they carrying?

Obviously, carrying a lot of debt is not good. Here you need to look at the financial leverage ratio (total assets divided by shareholders equity). A company with no debt has a financial leverage ratio of 1. The higher the ratio is, the more the debt. Avoid anything with a rating of 5 or over.

How's the cash flowing?

You want company's that have cash flowing in, not out. Look for positive numbers under the Net Cash from Operating column. Any positive number is a good sign, but if it exceeds the net income for that same period, it's even better.

Sticking with the stock buying basics can save you a lot of heartache!

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