6 Things to Look for When Buying Stock

Answer these questions to understand if you're making a good choice.

Couple seated on a sofa reviewing paperwork on the table
••• Jose Luis Pelaez Inc / Getty Images

New investors are often interested in buying a company's stock, but they're unsure whether it will be a good asset in their portfolios. Some factors can help you illuminate the better candidates and weed out those that might not be appropriate for you, from how long you plan to own the stock to the company's value.

Key Takeaways

  • Learning to use a company's market cap can help you keep from overpaying for an investment.
  • A declining number of shares but the same profit might indicate more value for an investor.
  • Look for long-term investments with a good price-to-earnings ratio.
  • Make sure you evaluate your reasons for buying a stock before you make the purchase.

What Is the Company's Value?

It's vital that you look at more than just the current share price when you're doing research. Check out the price of the entire company.

The "cost" of acquiring the whole corporation is called market capitalization, or market cap for short. It's the total value of the company's outstanding stock shares, including both restricted shares held by the company and publicly traded shares. Multiply the number of shares by the current stock price.

It's known as the corporation's enterprise value when you add its debt on top of it. In short, the market cap is the price of all outstanding shares of common stock multiplied by the quoted price per share at any given moment in time.

A business with one million shares outstanding and a stock price of $75 per share would have a market cap of $75 million: 1,000,000 shares outstanding X $75 per share price = $75,000,000 market capitalization.

The Importance of Market Cap

This market capitalization test can help you avoid overpaying for a stock. Consider the case of eBay and General Motors during the heyday of the internet era. eBay had the same market cap as the entire General Motors Corporation at one point during the boom.

To put that into perspective, General Motors Corporation made $4.5 billion in net income in fiscal 2000, while eBay made only $48.3 million, not including stock option expense. But you would have paid the same amount were you to buy either one.

It's almost unbelievable that any investor would pay the same price for both companies, but the general public was seduced by visions of quick profits and easy cash at the time.

Price-to-Earnings Ratio

Another useful tool to gauge the relative cost of a stock is the price-to-earnings ratio (P/E). You can calculate it by dividing the price per share by per-share earnings. This provides a valuable standard of comparison for alternative investment opportunities.

Is the Company Buying Back Its Stock?

One of the most critical keys to investing is understanding that overall corporate growth isn't as important as per-share growth. A company could have the same profit, sales and revenue for five consecutive years, but create substantial returns for investors by reducing the total number of its outstanding shares.

Think of your investment as a large pizza. Each slice represents one share of stock. Would you rather have one part/share of the same pizza that was cut into twelve slices or one that was cut into eight slices? The pizza that was only split into eight parts will have bigger slices with more cheese and toppings.

The same principle is true in business. A shareholder should look for a management team with an active policy of reducing the number of outstanding shares if alternative uses of capital aren't as attractive. This makes each investor's stake in the company bigger. Each share represents a higher percentage of ownership in the profits and assets of the business when the corporate "pie" is cut into fewer pieces.

What Are Your Reasons for Investing?

Ask yourself why you're interested in investing in a particular business before you add a company's share of stock to your investment portfolio. It's dangerous to fall in love with a corporation and buy it solely because you feel fondly for its products or people. The best company in the world is a lousy investment if you pay too much for it.

Ensure the fundamentals of the company — current price, profits and good management — are the only reasons you're investing. Everything else is based on your emotions.

Emotion leads to speculation rather than intelligent investing. Remove your feelings from the equation and select your investments based on the cold, hard data. Your goal should be capital appreciation and healthy dividend payments. This requires patience and the willingness to walk away from a potential stock position if it doesn't appear to be fairly valued or undervalued.

Be Willing to Own the Stock for 10 to 25+ Years

Buy shares in a company and go in with the intention of forgetting about them for the next 10 years, or five years at the absolute minimum. Professional money managers attempt to beat the markets all the time, but most fail to do so year after year.

One guaranteed way to success has historically been to select a great company, pay as little as possible for the initial stake, begin a dollar-cost averaging program, reinvest the dividends and leave the position alone for several decades.

Of course, this is more easily said than done when the market plummets due to unforeseen circumstances. But experts maintain that you should try to avoid panic and wait it out when at all possible.