Whether you’re a seasoned investor or a complete noob, choosing the right investment can be tough. What should I be looking for in a good investment? More importantly, how do I spot a bad investment?
Investment research involves more than just looking up the share price of a stock. It also involves looking into the details of a company and checking several metrics that describe its financial status. Researching investments is important because it helps investors develop an understanding of how a company operates, what risk it poses, and how much it rewards shareholders for tolerating that risk.
Using the information gleaned in their research, investors can determine the likelihood that they will make money in a particular investment. If they fail to do their research, they may not recognize all of the risks involved in an investment, so they can’t be surprised if they end up losing money.
Tactics for researching investments
|Type of Analysis||Advantage|
|Fundamental||Learning how a company operates, its size, and industries it has exposure to all provide insight about the risk that company poses for investors|
|Technical||The cyclical trends of a company’s share price may indicate whether it’s likely to move higher or lower in the near future|
|Economic||Allows investors to understand how an investment tends to react to various economic conditions|
|Top-down||Investors can start by limiting their search to the sectors you’d like to invest in, and then work their way down to individual companies|
|Bottom-up||Investors identify specific companies they may want to invest in, and then zoom out to assess risks of the industries they operate in|
When researching investments, there are several different methods that investors can employ. But first, it’s important to start by taking a look at some potential investments. Then, once you settle on a few potential candidates to consider, you can then decide which metrics to look at to verify whether an investment seems sound.
When looking into potential investments, there are several standard metrics that most investors look at. Which of these numbers is important to you will vary based on the type of investment you’re considering. So, you shouldn’t feel like you need to use them all – just consider these as arrows in your quiver, to be used when appropriate.
The market capitalization of a company is equal to the company’s stock share price times the total number of shares outstanding. Essentially, market cap represents the total equity value of the company. It helps investors understand whether the company is large or small, which is important because smaller companies tend to be riskier investments.
Earnings per share (EPS)
A company’s earnings per share (EPS) is equal to its total net earnings divided by the number of shares outstanding. This is a good number of investors to know, so they can see (1) whether it’s positive or negative and (2) how large it is. This is especially important relative to the company’s share price, as it’s an objective measure of the company’s profitability versus its size.
Price-to-earnings (P/E) ratio
Price-to-earnings (P/E) is a company’s share price divided by net earnings per share – it’s a measure of the profitability of a company relative to its share price. Investors can use P/E to determine whether a stock represents a good deal at a particular share price, which is important, since what investors are really buying when they purchase a share of stock is a portion of the company’s future earnings.
A company’s dividend yield is equal to its last dividend payment divided by the current share price, and is similar to the interest paid on a bond. This number is significant because it tells investors how richly a company rewards shareholders by distributing part of its net profits. A low dividend rate indicates that investors are not regularly rewarded with shares of a company’s profits.
Trailing 12-month return
An investment’s previous 12-month return is an indication of how that investment has performed over the preceding year (how much money it has made for investors). This figure includes changes in the company’s share price, as well as splits, dividends, or cash calls. The number indicates how an investment has performed during recent conditions, and allows investors to assess the likelihood of recent results continuing into the future.
Based on a company’s recent returns, some investors may decide they want to invest in stocks that have prices already on the rise, with the belief that they will continue higher. Others may prefer to target companies with stock prices that have recently declined, in hopes the share price will soon recover.
Of course, there are other metrics that investors can use as well – both trading metrics that are based on earnings and share price, as well as accounting ratios, such as a company’s debt-to-equity ratio or price to book value.
But, in most cases, investors tend not to care about these ratios based on accounting figures, as stock prices are not really based on company financials. Instead, investment prices are based almost exclusively on mass psychology, and investor sentiments about particular industries or companies at any given time.
The most common place to find information about potential investments is through a trading platform – you can find just about any of these basic metrics by looking up companies through online brokers like E-trade, Robinhood, or TD Ameritrade.
Of course, if you want to focus your research on other assets like ETFs or mutual funds, you may want to use a more specialized tool, such as Morningstar, to compare expense ratios or fund manager ratings.
Or, if you prefer to focus on fixed income investments, you may want to use a dedicated bond screener – although many online trading platforms have their own.
If you’re less curious about hard metrics and more curious about who a company’s largest shareholders are or whether insiders have been buying or selling shares of late, you can find most of this information through Yahoo!Finance.
Why investment research is important
Investing in anything involves risk. That’s why it’s important to research investments before you buy—so you can make sure that you understand those risks, know which ones apply to a given investment, and how. Here are some of the potential risks that research can help you identify:
- Company risk – The risk of a specific company losing money from its operations
- Market risk – Whether a broader market correction can hurt an individual company
- Currency risk – The chances of a company losing money if it does business in other countries involving foreign currencies
- Liquidity risk – The risk that you can’t convert an investment to cash quickly without taking a big loss
- Concentration risk – The risks that come with concentrating investments in just a few companies or asset classes
- Credit risk – The risk that a company will default on its debts (more important for lenders)
Thankfully, thoroughly researching prospective investments can help investors to identify and understand these risks. And, while investors usually can’t completely eliminate these risks through research, they may be able to find ways to help mitigate risks to their overall portfolio. And, if nothing else, they can at least make more informed investing decisions.
Editor’s note: If you’re looking to learn more about building wealth through investing, our friend Jeremy Schneider at Personal Finance Club has a terrific course on building wealth through investing in index funds.
The opinions expressed in this article are for general information purposes only and are not intended to provide specific advice or recommendations about any investment product or security. This information is provided strictly as a means of education regarding the financial industry.
Originally posted at https://thinksaveretire.com/investment-research/