Factors to Consider When Buying Stocks

New investor looking at factors to consider when buying stocks
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Finding the right price to pay for a stock or the best price to sell a stock is how investors try to make money in the stock market. It seems obvious, but like many things in life, it is not easy to do.

Find out some of the key elements you should look for when comparing and buying stocks.

Key Takeaways

  • The purchase and sale price of a stock are the most influential factors when considering a stock.
  • The stock issuer's earnings and free cash flow should be high enough to keep itself operating.
  • The stock issuer should be using its existing assets and equity to generate returns.

Buy and Sell Prices

The first task is to buy at the right price, but what is the right price? Different investors will have different answers, but they would agree that you should buy below what you think the future price will be.

Figuring out what price the market will pay for a stock in the future is difficult. There are many ways to come up with a future price. However, since we can't know the future for sure, an educated guess (a calculation) about the future price using past market conditions is best.

You may have a better chance of using the current market price, which may not be the same as how the stock is valued. You might also use intrinsic value to price a stock. The market price and intrinsic value are different assessments of a company's value.

Many investors use intrinsic value to determine the value a stock has to them, not necessarily to every investor. There are many different ways to calculate intrinsic value.

Intrinsic value considers the company's ability to generate free cash (cash remaining after all the bills are paid and current debt obligations satisfied) over time. A stock might be worth buying if its intrinsic value is greater than its market value.

Earnings

You should look for companies that post year-to-year growth in earnings (an occasional hiccup during recessions is acceptable). While this is not a perfect metric (remember, accounting changes can reduce earnings), it is one you should look at.

Ensure the target company is reporting earnings higher than its sector (but not too high, or it could be inflating its earnings). Also, compare it to major competitors.

Free Cash Flow

Strong companies generate a lot of cash and have a large flow of free cash. Free cash is what is left over after the company reinvests in itself to keep the business operating. It is money the company can use to fund expansions, buy other companies, pay dividends, or save for future use.

Free cash flow has a sister measurement known as free cash flow to equity (FCFE). While more complicated to calculate, FCFE can better measure the actual equity value of a firm, and in turn, its economic value to investors.

A strong free cash flow is an important signal that the company has a competitive advantage over competitors. How big of an advantage (or economic moat) the company has factors into deciding how strong the company's future looks.

Another way to think of this is how much cash you could pull out of the business without forcing a change in operations (closing plants, layoffs, and so on).

Return on Assets (ROA)

Return on assets (ROA) tells investors the company is using assets wisely and creating value for the owners. How efficient is the company in generating earnings? Strong companies have a superior return on assets to their sector.

When comparing companies for investing, it is essential to make sure they are in the same industry and have the same financial structure. If they don't, it isn't a good comparison.

For example, two companies each have $100 in assets. One company uses those assets to create $5 in earnings, while the other uses the same amount of assets to make $15 in earnings. Which would you choose to own?

Return on Equity (ROE)

Another way to look at a company's profit-generating efficiency figures is how the company uses debt in addition to assets. Since most companies use some debt to run the business, it is important to take it into consideration.

Return on equity considers how well the company uses investors' capital and includes leverage (debt). If a company has an ROE that is much higher than its sector, be alert for something unusual boosting the number (recent acquisitions, buying back stock, and so on).

Net Margins

A company's net margin is simply net income divided by sales. What this tells you is how efficient the company is in wringing profits out of sales. For example, some companies in specific industries (such as grocery stores) have low net margins and must drive a lot of revenue to generate profits. Other industrial sectors have higher net margins thanks to the nature of the business (software, for example). Great companies beat sector averages and close competitors.

Finding solid companies with promising futures takes some work, but investors willing to put in the time can be richly rewarded. Remember, you can find companies in any industrial sector worth investing in, so don't confine your search to the currently hot sector.