Investing in stocks is one of the most popular ways to grow wealth. If you’re new to stocks or investing in general, it can seem daunting to think about buying stocks.
With over 2,700 stocks on the New York Stock Exchange alone, it’s easy to find yourself overcome with thoughts like:
- How do you know which stocks will make for good assets in your portfolio?
- How long should you hold onto stocks?
- How can you identify good and bad stocks?
While there isn’t a foolproof method for buying stocks, basic research can help you identify critical factors that predict loss or success. Here are some basic metrics and factors you should consider before investing in stocks.
5 Things to Look For When Buying Stocks
It doesn’t matter if it’s individual stocks, mutual funds, exchange-traded funds (ETFs), or index funds. All investors can benefit from researching the company and its past performance before you invest.
Before investing in a company’s stock, here are five things you should do:
- Research the Company
- Evaluate the Price-to-Earnings Ratio
- Gauge Risk with Beta
- Examine a Stock’s Dividends
- Learn to Read Charts
1. Research the Company
When you purchase stocks in a company, you’re really purchasing partial ownership in the company. If the company does well, the company’s shares will become more valuable. If they don’t do well, you could lose money on your investment. This is why it’s critically important to understand everything you can about a company before investing in its stocks.
Researching a company goes far beyond knowing what a company does. It would help if you understood its revenue, costs, competitors, advantages, risks, opportunities, and more. You should examine its market capitalization to see if its stock is overpriced or undervalued. You should also question whether the company is governed by socially-responsible leadership or if it is likely to face criticism from consumers.
Doing your homework goes a long way when it comes to stock picking. But you should think about more than just what the numbers say.
Warren Buffet once said, “Buy into a company because you want to own it, not because you want the stock to go up.” This is an excellent mindset to adopt as you research companies in which to invest.
You will likely be disappointed if you buy stock strictly because you want the stock price to increase. If you invest in a company because you believe in its mission and future success, you are more likely to be more engaged and enthusiastic about investing.
2. Evaluate the Price-to-Earnings Ratio
One of the most common metrics used to determine the relative cost of a stock is the price-to-earnings ratio. The price-to-earnings ratio (P/E ratio) is calculated by dividing the stock’s price by the company’s earnings per share (EPS.) Investors use this metric to determine the stock’s valuation compared to other companies.
Need a real-life example to demonstrate what price-to-earnings means? Imagine that you’re a small business owner, and you’re seeking to hire a consultant to help grow your business. You are torn between two consultants: the industry veteran and the up-and-comer.
The industry veteran has a promising background. They’ve worked with hundreds of small businesses during their career and have helped many reach next-level success. Their expertise comes at a cost, though. They say that during the time you work with them, you will pay roughly 40 cents on every dollar you make. Given their track record, this seems to you like a fair price for their services.
The up-and-coming consultant is a rookie, but they have a lot of promise. They are passionate, driven, and seem to know their stuff. Their track record is much shorter than the industry veteran, so it’s hard to tell if their drive and enthusiasm will translate to results. They offer you a price that is half what the industry veteran charges, 20 cents on every dollar you make.
This example illustrates what information we can glean from a P/E ratio. You can expect blue-chip companies, such as Amazon and Apple, to have higher P/E ratios because they have long track records of success, and we can expect them to continue to be successful. Fresher faces on the stock market should have lower P/E ratios because they haven’t proven to be as consistently successful as the top dogs. If a company has the same P/E ratio as the Amazons of the world, there had better be a reason.
3. Gauge Risk with Beta
If there’s anything investors have learned this past year, it’s that your portfolio will take a downturn eventually.
In the case of this past year, global events independent of any particular company, board of directors, or management decisions contributed to the bear market that all three major stock market indexes find themselves in. Average market risk is anticipated whenever you invest in any stocks, options, ETFs, or index funds and can typically be marginally offset through diversification. There is a way, however, that investors can estimate a stock’s volatility outside of regular market risk.
Beta is a measure of how volatile a stock is in comparison to the movements of the S&P 500. If you think of the S&P 500 as a pillar of stability, beta measures how much a stock’s performance rises or falls in value compared to the index over five years. Any stock with a beta of over one is considered high risk, and stocks with a beta below one are regarded as low risk.
When reviewing a stock’s beta, looking at the context is essential. For example, a stock with a high beta (a stock that moves in more pronounced ways than the S&P 500) may offer higher returns in a bull market than a low-beta stock. On the other hand, high-beta stocks are not preferable in bear markets like the one we’re in now.
A stock’s beta is listed on a standard stock screener, such as TD Ameritrade. Consider your overall investing goals when you decide whether to invest in high or low-beta stocks.
4. Examine a Stock’s Dividends
Some people love checking stocks and seeing which shares have appreciated in value since they acquired them. Others, however, don’t have that sort of time or attention to devote to their stock accounts. If you want your stock investments to earn money outside their price appreciation, look for stocks that carry dividends.
Dividends are annual payments a company gives shareholders in exchange for holding several shares. Think of it like the interest you earn on a savings account. The company’s board of directors decides the annual dividend, typically based on the profits made that year.
Many investors like dividend stocks because they offer a reliable source of income and can come in handy in times of economic uncertainty. Most companies will issue dividends in cash, but others may offer additional shares as dividend payouts.
So what should investors look for when checking out a company’s dividend yield? First, you should be wary of any company that promises a high dividend payout (7-8% or higher.) High-yield dividends may indicate that a company’s stock has taken a significant downturn, or it could signal that dividends are short-lived and may disappear for stockholders in the future.
If you are interested in investing in dividend stocks, look for stocks that offer 2-6% dividend rates. These are typically realistic rates to expect without taking on too much unnecessary risk.
5. Learn to Read Charts
If you want to get into stock investing, learning to read stock charts is a skill that sets you apart from many beginner investors. Most people buy stocks without fully understanding anything more than the rise and fall of their share price.
Learning to read stock charts isn’t always easy, but it will help you understand the trajectory of a company and whether or not you want to back them with your hard-earned money.
Stock charts help you understand historically what has happened to a company’s shares in the stock market. You can track the rise and fall of its market price. See if a stock is held under any mutual funds. Look at the outstanding stock to see the number of shares a company has available for purchase (this can also tell you whether or not a company has been repurchasing its own stock.)
Understanding factors beyond just share price can help inform your decision to invest. Ultimately, learning to read stock charts will help you become a more informed investor and feel more confident in your investment decisions.
Why Invest in Stocks
Why you should invest in stocks will depend heavily on your investing goals.
Investing beginners may be interested in building their investment portfolio to grow their wealth and improve personal finances. Older investors may be interested in preserving the earnings of their investments as they are in retirement planning. Some investors even seek to earn regular income from their investments through distributions or dividends.
Considering your investing goals can help guide the time horizon and investment strategy as you purchase stocks. Time horizon refers to the time you plan to hold onto a particular stock. There are three investment time horizons to consider:
- Short-term investments are typically held for a year or less. Blue-chip stocks, like Apple or Amazon, make the best short-term investments because they pay high dividends and usually have steady, stable growth.
- Medium-term investments are typically held from one year to ten years. If you seek returns in a middle-term time horizon, you can invest in emerging markets with slightly higher risk than blue-chip stocks.
- Long-term investments, which are held for more than ten years. These investments have a much higher risk tolerance and can have high yields if held for a significant period.
Ultimately, stocks allow your money to grow with the market more than if it was just sitting in a savings account. When you place your money in investments, you can offset the effects of inflation and prevent your money from losing its value over time.
Frequently Asked Questions
What should you look for in dividend stocks?
The two metrics that can tell you a lot about what to expect from stock dividends are dividend yield and dividend growth rate. The dividend yield is the number of dividends you can expect from a company for every dollar you invest. The dividend growth rate is the rate at which you can expect your dividend to grow yearly.
How is day trading different from regular stock trading?
Day traders look at stock buying very differently than long-term stock investors. Long-term investors look at metrics that track business fundamentals, while day traders look at metrics that track stock volume and volatility. This is because they typically only hold stocks for a short period, as short-term as a few hours.
How do I get started investing in stocks?
Before you begin purchasing stocks, you need to choose a broker and create a brokerage account. You choose from traditional financial advisor firms like Charles Schwab or Fidelity, or you can opt for a robo-advisor, such as Robinhood or Acorns.
Final Thoughts
Nothing is more critical to the investment process than research, research, and more research. While you don’t want to get trapped in a research rut, you should always feel fully informed about a company and its share’s history before you put your money behind it.
By understanding some key terms and digging deeper into where a company’s stock stands, you can confidently begin investing in stocks.
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