3 of the Best Questions to Ask When Considering a Stock

3 of the Best Questions to Ask When Considering a Stock

Making an initial step into the world of investing can prove daunting, especially when entering the stock market. Beginners often don’t know how to make the best decisions about buying and trading, and the perceived learning gap discourages them from trying. However, as people dive into the world of stocks, they start to learn what to look for when choosing stocks and slowly develop a set of guidelines that they can use to vet new options.

The following is a series of basic questions that individuals may want to consider when looking at stocks:

  1. What is the company’s cash-flow situation?

When looking at a potential investment, amateur investors are often primarily concerned with earnings to the extent that they do not consider cash flow at all. These two factors are very different. Someone who makes a great deal of money could encounter cash-flow problems if paychecks only come every few months. With modern accounting practices, people cannot rely on earnings to determine cash flows. Instead, individuals should look at annual reports, which spell out exactly how much money went directly into the company’s pockets.

cash flow

Even more important is the question of how the company uses the cash that it earns. This question gives potential investors insight on the company’s management strategy. If the company is constantly opening new stores or building new facilities, it is likely building the future. Companies may also use income to buy other organizations, pay off debt, build reserves of cash, or even buy back stock. Hopefully, the company is also using its cash to pay dividends.

The opposite of cash flow is debt. Companies may go into debt to drive research or build new facilities when they experience short-term cash problems. While debt is not inherently bad, it can grow out of control and eventually lead to an organization’s collapse. Companies should not be using so much of their cash flow to pay interest that they cannot invest in their own future. A good tool for assessing debt is financial leverage, which is the quotient of assets to equity. Appropriate levels of debt may also vary by industry.

  1. What exactly does the company do?

This question may sound too basic, and for some companies it will be very easy to answer. However, a number of firms offer a wide range of different products and services, and large conglomerates can even have hundreds. Before investing, individuals need to take the time to research what exactly the products and services are in addition to how the company has developed them over time. If, in the last year or two, the company has added a number of new services that seem unrelated to the company’s initial mission, then the organization is likely trying to target new markets.

Having a clear sense of a products and services will also give potential investors a clear idea of what is necessary to drive success. If the company provides novelty items, then the prospect of an economic downturn could mean its demise. On the other hand, a company that provides in-home healthcare products could potentially grow as more Baby Boomers reach old age and begin to experience health problems. Importantly, product lines can also show exactly where profits come from. Some companies may not sell a lot of a certain product, but this does not mean that a significant portion of earnings do not come from those sales. What market conditions might affect the products that earn the most money for a company?

The best place to find information about these questions is the company’s annual report that it files with the Securities and Exchange Commission. The report will give breakdowns of sales and income based on product. Potential investors should also look at the shareholders’ letter and product presentations on file.

  1. What are the company’s sustainable competitive advantages?

Groupon LogoCompanies that are growing quickly and turning a profit will have competitive advantages in the marketplace, but how sustainable are these factors in the years to come? People should focus on investing in companies that can maintain their relevancy for the foreseeable future. Just because a company sounds like a great idea does not mean that it is an ideal investment. One great example is Groupon, which had incredible surges in stock when it went public. Since then, however, the stock as plummeted because its competitive advantage was not sustainable. As other similar companies became popular and cities created their own “deals” organizations, Groupon became obsolete.

When comparing Groupon to Amazon, the concept of a sustainable competitive advantage becomes clearer. Amazon has a large network of fulfillment centers that are able to provide product in days or even hours. This network cost billions of dollars to build, and companies that want to compete with Amazon would have to similarly invest billions of dollars for only a portion of the available market share. Because no company is likely to do this in the near future, Amazon has a long-term market advantage.