8 important questions to ask before buying any stock
Many investors buy stocks on a whim, either because the stock is hot or at the suggestion of a financial pundit. Most of us don’t have the ability to research stocks full-time, so it can be easy to make an impulsive purchase. If you want the help of someone who does research stocks full-time, you may want to rely on a financial advisor.
Either way, it’s important to have a baseline understanding of what you are buying. Investing always involves some risk, but asking the right questions can help make your portfolio’s performance a bit less volatile.
Before buying your next stock, ask these eight questions.
Questions to answer before investing in a stock
1. What does the company do?
Having a basic understanding of what the company does is crucial. It helps you assess risks, see how the business stacks up against competitors and gauge its potential for growth. Plus, it’ll make its financial reports much easier to decipher.
For example, suppose you are considering a business that manufactures conduits for refrigeration and heating systems. It isn’t necessary to know every step of the manufacturing process, but you should have some idea of what those conduits do.
Ultimately, a solid grasp of a company’s business is essential for making informed investment decisions and mitigating risks. So, before investing your money, do your homework. Figure out what the company does, how it makes money and its growth prospects. Remember, understanding the basics can save you a lot of headaches (and a lot of money) in the long run.
2. Is the company profitable?
There are many reasons you might consider investing in a company. Perhaps the business is an exciting startup or a big company with one of the best-performing stocks on the market. But the reality is that companies that fall into either category could lose money.
If a business is consistently losing money, it might be a warning sign. While there are plenty of pre-revenue companies that may be good investments, there is also an increased risk of insolvency or of the company turning to secondary capital raises and diluting shareholders in the process.
To determine whether the company is profitable, you can read quarterly and annual reports, which all publicly traded companies must file with the SEC. In these reports, you will find figures like net income, net profit margin and net change in cash. If these numbers are regularly positive, it’s a sign that the company is headed in the right direction financially.
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3. What are its EPS and P/E?
Another set of numbers to investigate is the price-to-earnings (P/E) ratio and earnings per share (EPS). These will give you a clue whether the company is potentially overvalued or undervalued. For instance, the business might be overvalued if its P/E ratio is high because the price is high relative to company earnings. But if its EPS is high, it might be undervalued because it has a high amount of earnings for each share.
Whether these numbers are high or low is relative to the company’s direct competitors. Thus, the standards might be different for different industries. For example, there are 70 companies in the aerospace and defense sector, and the sector has an average P/E ratio of 36.96, according to a January 2024 analysis by Aswath Damodaran, corporate finance and valuation professor at New York University. But the air transport segment, which has just 25 firms in the sector, has an average P/E of 2,426.56.
When evaluating a stock, you generally want to look for a P/E ratio that is below the industry average. However, keep in mind that a high P/E is not always a bad thing; it could be a sign that investors are expecting significant earnings growth in the future.
4. Who are its competitors?
Just like a business should know its competition, so should its investors. This is important because it can clue you into possible challenges. If the company you are considering operates in an industry with fierce competition, there could be constant threats to its bottom line. That could hurt its profitability and thus its long-term viability as an investment.
5. How does the company differentiate itself?
Differentiation is all about doing something unique that sets a company apart from its competitors. It could be a special product, outstanding service or even just a different way of doing business.
Why does differentiation matter? First, it can help a company charge more for its products or services. If you’re offering something that nobody else has, you can usually get away with a higher price tag. Plus, it can help build customer loyalty. People tend to stick with brands that they love and that offer something unique.
For example, Apple is one of the largest companies in the world and stands apart from other technology titans. Apple’s tightly integrated product line of hardware, software and services creates a unique user experience that’s difficult for competitors to replicate.
6. What are its plans for the future?
It’s not uncommon for businesses to discuss their plans for the next year or two. Perhaps they have major products or services they intend to release soon, or maybe they are working on some mergers and acquisitions.
Look for press releases and news reports with information about their plans for the future. If you find information about several upcoming projects, it’s a good sign that the company is working tirelessly to remain competitive.
7. Does it reward its investors?
Does the company you are considering give back to its investors? In the form of dividends, that is. Dividend stocks provide a regular cash payout — truly passive income — which can make these stocks great long-term investments.
Often, businesses that have been around for decades in mature industries will issue dividends regularly. On the other hand, if it’s a startup in an emerging industry, it may not issue dividends because it’s investing heavily in research and development (R&D). While there are pros and cons to either scenario, it’s good to set proper expectations as an investor.
8. Are other investors bullish?
Some stock analysis platforms will give you clues about investor sentiment. In some cases, you might see this information in your brokerage account (the best online brokers provide third-party or in-house stock research, analysis and reports for free). If sentiment is strong across the board, it might be a sign that you’re looking at a good investment opportunity — or that the stock is overhyped.
Investor sentiment shouldn’t necessarily make or break your decision. Nevertheless, it’s another factor to consider.
Bottom line
While it might be tempting to buy whichever stock is hot at the moment, it pays to be more methodical in your approach to investing. Instead, ask yourself key questions about the company itself, as well as its profitability and competition. If the stock looks strong after asking yourself these key questions, you might have a strong investment opportunity. If not, it might be best to look elsewhere.
— Bankrate’s Rachel Christian contributed to an update of this article.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
