TomorrowMakers

These questions will help you make wise investment choices

6 Questions to ask before you invest in a stock

Investing in stocks is as much an art as it is a science. It is essential to assess how the investment fits in with your goals, risk appetite and overall portfolio construction. There are various strategies on how to analyse a stock before investing. However, there are certain qualitative and quantitative questions women should consider before making an investment decision.

Here’s what to know before buying stocks:

What is the company’s market cap?

Market capitalisation reflects the business valuation and the perception of its future prospects in the open market. It allows investors to evaluate the size of the business and growth relative to its peers. 

Market capitalisation by itself is not a strong indicator of future growth. However, businesses with a lower market cap tend to be volatile and susceptible to industry or economic downturns. On the other hand, businesses with large valuations are built on a solid reputation, have an established product/service suite and deliver consistent growth. 

What are the company’s trading volumes?

The active trading volume gives you a strong understanding of the liquidity and the market sentiment surrounding a stock. If the trading volumes are low, it can become difficult to exit the stock as and when you wish. Lower trading volumes also produce sharp price movements. 

Investors should use a 14-day average to get a fair idea of the liquidity a stock presents. Many investors also use trading volumes to identify the momentum or direction in which a stock might move. An uptick in volume and price indicates a positive momentum, whereas an uptick in price with low volumes may indicate stock manipulation. Long-term investors with a passive portfolio management approach should ideally avoid illiquid stocks.

What are the company’s operating profits?

Operating profits refer to the net income after accounting for the cost of production, operational expenses, wages, etc., and before taxes. This gives an insight into the company’s operational efficiency and income generated against capital investment. 

A higher operating margin is a good indicator of how the business and its resources are being managed. Startups and new-to-market businesses that raise equity are in the stage where they are deploying capital and probably years away from seeing any significant revenue. These businesses are most vulnerable during market corrections or economic uncertainty as they do not have any financial cushion. Risk-averse investors should look for businesses with an operating margin of at least 12-15% or more.

Does the company generate constant cash flow?

A business’ cash flow is a good metric to evaluate the financial health and earnings vis-à-vis stock price. Corporations that generate a positive cash flow indicate good long-term prospects and are better poised to generate shareholder value. Investors looking for dividend earning stock usually seek out companies with a strong cash flow. Established businesses that do not have a positive cash flow may be in an expansion stage. Conversely, cash-flow-negative companies may need to raise additional capital, which could dilute shareholder earnings and drive stock prices down.

Does the company deliver an acceptable Return on Equity (RoE)?

Return on Equity measures a company’s profitability as well as efficiency. It lets you know how well the business uses the capital available and performs compared to its competitors in the same industry. RoE is arrived at by dividing the net income by equity. 

As a thumb rule, an RoE over 10% is acceptable, and anything above 15-20% is considered good. However, the baseline RoE will differ from industry to industry. For example, service businesses, such as those in the technology or retail space, tend to deliver higher RoE compared to capital intensive industries, such as manufacturing or energy. 

Does the company make quality disclosures?

Investors have to make their investment decision based on the information the company gives out in the public domain either through its website, annual reports or press releases. While businesses are mandated by SEBI to disclose all financial details, it is crucial that the company makes a fair evaluation of its performance, and there is no window dressing. The company should outline future prospects and anticipated challenges. 

Another soft factor to look for is how receptive the company is to shareholder concerns and recommendations. Businesses that are fair and transparent foster greater shareholder trust, a critical factor for long-term investing.

So, as you begin to select a stock, remember the art and science of logical thinking when investing.