5 Essential Things You Need To Know About Every Stock You Buy
1. What They Do
Jim Cramer, in his book "Real Money," advises investors to never purchase a stock unless they have an exhaustive knowledge of how they make money. What do they manufacture? What kind of service do they offer? In what countries do they operate? What is their flagship product and how is it selling? Are they known as the leader in their field? Think of this as a first date. You probably wouldn't go on date with somebody if you had no idea who they were. If you do, you're asking for trouble.
This information is very easy to find. Using the search engine of your choice, go to their company website and read about them. Then, as Cramer advises, go to a family member and educate them on your potential investment. If you can answer all of their questions, you know enough.
2. Price/Earnings Ratio
Imagine for a moment you were in the market for somebody who could help you with your investments. You interview two people. One person has a long history of making people a lot of money. Your friends have seen a big return from this person and you can't find any reason why you shouldn't hand this guy your investment dollars. He tells you that for every dollar he makes for you, he's going to keep 40 cents leaving you with 60 cents.
The other guy is just getting started in the business. He has very little experience and, although he seems promising, he doesn't have much of a track record of success. The advantage to this guy is that he's cheaper. He only wants to keep 20 cents for every dollar he makes you - but what if he doesn't make you as many dollars as the first guy?
If you understand this example, you understand the P/E or price/earnings ratio. If you notice that a company has a P/E of 20, this means that investors are willing to pay $20 for every $1 per earnings. That might seem expensive but not if the company is growing fast.
The P/E can be found by comparing the current market price to the cumulative earnings of the last 4 quarters. Compare this number to other companies similar to the one you're researching. If your company has a higher P/E than other similar companies, there had better be a reason. If it has a lower P/E but is growing fast, that's an investment worth watching. (If these numbers have you in the dark, these easy calculations should help light the way, see How To Find P/E And PEG Ratios.)
Beta seems like something difficult to understand, but it's not. In fact, and can be found on the same page as the P/E Ratio on a major stock data provider such as Yahoo or Google. Beta measures volatility or how moody your company's stock has acted over the last 5 years. Think of the S&P 500 as the pillar of mental stability. If your company drops or rises in value more than the S&P over a five-year period, it has a higher beta. With beta, anything higher than 1 is high beta (meaning higher risk) and anything lower than 1 is low beta (lower risk). (Beta says something about price risk, but how much does it say about fundamental risk factors? Check out Beta: Know The Risk.)
You have to watch high beta stocks closely because, although they have the potential to make you a lot of money, they also have the potential to take your money. A lower beta means that a stock doesn't react to the S&P 500 movements as much as others. This is known as a defensive stock because your money is much safer. You won't make as much in a short amount of time, but you also don't have to watch it every day.
If you don't have time watch the market every day and you want your stocks to make money without that kind of attention, look for dividends. Dividends are like interest in a savings account. You get paid regardless of the stock price. Dividends of 6% or more are not unheard of in high quality stocks. Before purchasing a stock, look for the dividend rate. If you simply want to park money in the market, invest in stocks with a high dividend. (For more, see Why Dividends Matter.)
5. The Chart
Learning to read a chart is a skill that takes time, but basic chart reading takes very little skill. As famed investor Dennis Gartman says all the time on CNBC, if an investment's chart starts at the lower left and ends at the upper right, that's a good thing. If the chart is heading down, stay away and don't try to figure out why. There are thousands of stocks to choose from without picking one that is losing money. If you really believe in this stock, put it on your watch list and come back to it at a later time. There are many people who believe in investing in stocks that have scary looking charts, but they have research time and resources that you probably don't.
The Bottom Line
Nothing takes the place of exhaustive research. However, one key way to protect your assets is to invest for the longer term by taking advantage of dividends and finding stocks with a proven record of success. Unless you have the time, risky and aggressive trading strategies should be avoided or minimized.