Financial investments are one of the most important assets in people’s lives. Yet many investors receive little education or training before putting their hard-earned money to work in the stock market. Lured by the prospect of realizing high returns, investors often learn by trial and error – and unfortunately, investment mistakes can be quite costly.
To help limit risks of a painful loss, consider asking these 10 questions before buying or holding onto a stock. Keep in mind that investing involves continual maintenance, as companies are constantly evolving and changing. The list of questions should be reviewed each time a company reports its quarterly earnings and whenever a company announces a major transaction that will affect its earnings, such as a large acquisition.
What does the company do?
This sounds very basic, but many investors purchase a security without having this core understanding. In your own words, write down exactly what the company does and if your message is not clear – do more research. Sources of information are: the company’s website, a recent annual report or MD&A (management’s discussion and analysis). For Canadian-listed companies, news releases and financial reports can be found at sedar.com.
What is the company’s revenue breakdown?
It is important to know what drives a company’s earnings. Notice whether sales growth is accelerating or decelerating, and how the revenue mix is shifting over time if there are multiple revenue streams.
How profitable is each business segment?
A common and important measure of profitability is the EBITDA (earnings before interest, taxes, depreciation and amortization) margin. If a company has several revenue streams, a positive attribute is to see a high-margin revenue segment growing and representing an increasing portion of the company’s total revenue. Broadly speaking, you want to see profitability margins rising.
Is there growth – both top line and bottom line?
Is the company’s revenue growing year-over-year? If so, how much of this growth is organic, or internal, compared with acquisition growth? It is important to see organic growth. For instance, a company may show impressive year-over-year sales growth, however, it could all be from a recent acquisition while sales within its existing operations are actually declining. Is the bottom line – earnings a share – increasing year-over-year? Can the earnings growth support its dividend payout and dividend increases?
How leveraged is the company?
A common metric to look at is the net debt-to-EBITDA ratio. If this ratio is too low for an extended period of time, the company may not be fully optimizing its growth potential. A ratio that is too high may be a warning sign that future growth may stagnate. You want to see a ratio that provides a company with the financial flexibility to fund both its organic and acquisition growth opportunities.
What is management’s track record?
Does the management team deliver on its promises? If management provided specific earnings targets in the past, did it achieve them? A conservative management team will underpromise and overdeliver. That is, it will set modest expectations and report operating results that exceed these targets.
Are earnings revisions positive or negative?
For the most part, positive revisions by analysts to the consensus earnings estimates are desirable. That said, a negative earnings revision is not always cause for alarm: For instance, it could simply be the result of a large divestiture.
What is management’s outlook?
The market is forward looking. While historical information is important, anticipated future financial performance drives a stock price. While management will often provide its earnings outlook in its earnings release or MD&A, listening to the earnings call is crucial. Analysts will often pepper the management team with questions surrounding its future growth as they have to try to accurately model the company’s future earnings in order to come up with an appropriate valuation (target price) for the stock. Listen to the live conference call or the replay. Conference call numbers are typically mentioned in a news release that is posted on the company’s website.
Does management have “skin in the game”?
A large ownership position aligns management’s objectives with shareholder’s objectives.
Finally, what is the stock’s valuation?
This is one of the most important factors to consider. It involves calculating a stock’s intrinsic value and comparing this value with the current share price. There are a number of ways to calculate a stock’s intrinsic value, including using a discounted cash flow model, and multiplier models (price-to-earnings and price-to-book ratios, for example). You can have a company with a lengthy list of attractive attributes (such as a strong management team and solid fundamentals), but a high valuation can sometimes be a caution sign, suggesting that investors may want to wait for a better buying opportunity. Furthermore, a stretched valuation may represent a selling opportunity for prudent investors to take some profits off the table.
Jennifer Dowty