Unless I’m mistaken, if you want to invest your money in the stock market, it's because you want to make more money. To build your nest egg. To grow your bacon. The most straightforward option is to put all of your money in ETFs, forget about them, and sit back and relax up until you retire.
But if you like to get your hands a little dirty, you can invest in individual companies that you pick. But how do you pick? You have two options: you can invest blindly while listening to the advice of your in-laws (“Mark my words! Nortel will go back up!”), or you can do your homework.
If you prefer to know what you're doing, here are six small things that you should definitely know about a company before you buy their stocks.
1. What does the company do?
It is the most obvious question. But many people invest in companies they can't even describe. “My uncle told me the price was about to skyrocket because [insert foolish reason].” Fine, okay… But what does the company do?
Do they sell ice cream or do they produce turboreactors for spaceships? What’s their story? What's their unfair advantage? What are their short and long term goals? Did they recently buy another company? And the company that they just bought – is it doing well or crashing?
Inform yourself. For this, I recommend you check out the “Investors” section on their website. There, you can find annual reports that, at first glance, look a bit indecipherable. But they are abound with a ton of information that can help predict its success (for example, their price-earning ratio, which I explain in point #5).
2. What industry are they in?
Zoom out on your company. In what industry does it operate? McDonalds, Burger King and Tim Hortons are all in the same industry. Metro, Sobeys, Zehrs: competitors in the same game. Walmart specializes in retail shopping, whereas Boeing makes airplanes. And there’s a world of difference between them all.
Ideally, you want to invest in an industry that is growing – that has potential and a bright future. But beware. In the early 2000’s the price of any share in a company ending with .com was worth billions. This was called the dot-com bubble. And in the end, it burst.
3. What are the barriers to entry?
Do they have a sophisticated security system at their office headquarters? This is not what we mean by barrier to entry. An example to illustrate:
According to Wikipedia, Canadian National Railway Company (CN) owns 28,200km of train tracks. How much money would it take to lay 28 thousand kilometers of tracks today? Probably mega-millions. So does CN exists in a market with a high barrier to entry? Yes. Yes they do. Because at this point, no one else can sneak in and replace what they do.
The barrier of entry has a lot to do with the popularity of a product. Pepsi and Coca-Cola are recognizable worldwide. The amount of marketing it would take to overthrow these brands would be astronomical. You would have a hell of a time convincing everyone that your new pop is better than theirs.
But don't be fooled by only choosing industry leaders, because some giant companies have a tendency to rest of their laurels. Instead, you should favor the company prioritizes consistent growth. In the end, those companies will beat their competition who are twiddling their thumbs at the top.
Especially for long-term investments, you should focus on companies that have high barriers to entry. Companies that are doing something nobody else can do? They have a lower risk of being eclipsed by the competition.
4. How are the company's finances?
I could give you a list of a dozen ratios to check before investing in a company. But more important than learning those acronyms is to understand the big picture of a company's finances.
Is their revenue rising or falling? How are their sales? Are they in debt? Does the company owe a lot of money, or have millions in cash?
Knowing a little bit about accounting helps – but it's not hard to understand that more debt is probably bad, and so are falling revenues. Personally, I look for profitable companies that are growing steadily, who have little debt and lots of cash.
Where can you find this information? On the Investors section of their company website (in those pesky annual reports), or in Google Finance Reports – look at Company Financials and their total revenue for the past 1-5 years.
5. What is their Price-Earnings Ratio?
Even if a company is truly exceptional, you should not buy their stocks at any price. To determine if a stock is affordable, look at its Price-Earnings Ratio (or P/E ratio). The P/E ratio shows you how much profit you make per share compared to the price of the stock.
An example: if a company owns 200,000 shares and earns $100,000 per year, that means investors earn 50 cents per share (because $100 000 profit divided by 200 000 shares = $0.50 each). If a share costs $10 on the stock market then the P/E ratio is 20, because the price ($10) divided by the earnings ($0.50) is 20. Overall, you pay 20 times the annual benefits for the stock that you bought.
With a P/E ratio of 20, if the company gave all of its profit to its shareholders (which will never happen, and if it does it's probably going bankrupt), the investor would have to wait 20 years to earn back his initial investment. That’s a long time – but he would still own his shares and could sell them afterwards to make even more money.
Ideally, you want a company with a low price earnings ratio, below 15 – 20. Of course, don't ignore all companies with a higher ratio. It could be a temporary overvaluation of the stock price. Couche-Tard (which own the Mac’s convenience stores) has a P/E ratio of almost 24 right now. That might seem a little overvalued, but is it that bad a decision? One way to decide is to compare the company to its competitors. To give you some context, the PE ratio of the S&P 500 is around 25 right now.
6. Who is in charge?
You want to know the tendencies of the people operating the business.
In a perfect world, you would call up the CEO, go for a beer with her and afterwards make a judgement : either yes, she seems like a good character and she knows what she’s doing. Or maybe the opposite. But since you’re probably not the manager of a fund which owns 10% of the company, it’s hard to get her to return your phone calls or LinkedIn messages. So you turn to the Internet.
You’re looking for an ideal leader: honest, frank, ambitious and motivated to repay their shareholders on the long-term. Shockingly, you can often see their attitude in the annual reports. If the report is too optimistic, it’s a warning sign. You want a management team that will be honest about their failures as much as their successes. The best example: Warren Buffett. If you read the annual reports of Berkshire Hathaway, you'll find he’s the first one to tell you what's going wrong with the company.
Ultimately, remember that you’re giving your money to other people to make it grow. The least you can do is to know the basics of the company's mission and business plan to see whether or not they deserve it. Because if you're giving your money to anyone, it's almost like throwing it out the window.
This article was compiled by Hardbacon, which has designed an online broker comparator listing dozens of Canadian online brokers. Hardbacon also helps you save on savings accounts, chequing accounts, credit cards, robo-advisors, life insurance, mortgages and personal loans. If you want to go one step further and take control of your finances, you should download Hardbacon’s mobile app, which links to your bank and investing accounts, helps you plan for your financial goals, create a budget and invest better.