Check It Twice: 6 Things to Consider Before Buying a Stock

If you’re waiting until the market bottoms out to buy stocks, you may wait a long time.

That’s not because I expect a prolonged bear market, although that is certainly possible. Rather it’s because no one can identify a bottom or peak except in hindsight. Anyone who claims they can time the market on a consistent basis is lying.

So, when is the best time to buy stocks? Any time, as long as you follow certain basic rules. The market is cheaper now than it was last January. It’s more expensive than at the end of September. I can’t tell you where it will be in six months. I can predict with some degree of certainty that it will be higher in five years.

With all this in mind, I’ve put together a stock shopping list. Use it to judge the appropriateness of any security you may be considering.

1. Suitability

Before you buy a single stock, you must have a strategic plan. What is your investment objective and how much risk are you prepared to take to achieve it? There is no point buying stocks that don’t fit your plan. For example, if you’re investing for income, non-dividend stocks are not appropriate. If you’re looking for growth, avoid sectors like utilities.

2. Profitability

After suitability, I rank this at the top of my priority list when judging whether to buy a stock. After subtracting expenses from revenue, what’s the bottom line? If a company is making money, I’m interested in exploring it further. If it’s not, I’m sceptical.

There are other measures that some organizations focus on to prove their viability. EBITDA is one. Funds from operations (FFO) is another. I don’t dispute that these offer useful insights into a company’s financial performance. But my strong preference is to see it all proved on the net earnings line. 

3. Affordability

A company may be profitable but is it fairly priced – in other words, affordable? We’ve just seen the shares of many profitable tech companies slapped down because their p/e valuations got totally out of whack. Look at Amazon. It’s making money, but investors were paying too much for those earnings. When momentum was working in the company’s favour, that didn’t matter much. But Amazon shares are down almost 50 per cent in the past 12 months, and the p/e ratio is still in nose-bleed territory at about 84. Apple, by contrast, has a p/e under 25. It’s clear which has a better affordability rating at the moment. 

4. Cash flow

We see bulges in the market all the time, where one or two sectors gain dramatically more than the broad range of stocks. Energy is that sector right now. Tech was the big winner during the pandemic. The trends come and go. Try to look beyond them and focus on what it all means to your net worth. Cash flow is one measure, especially if you’re income-oriented. How much money do you receive in dividends from a security and how sustainable are those dividends?

Some companies have a long history of steadily raising their dividend pay-outs. Utilities like Fortis and Canadian Utilities have been doing so for almost 50 consecutive years. Banks, when they’re not constrained by government regulation, as during COVID, have a good track record. So do telecoms. Energy companies are more of a gamble; dividends tend to be closely tied to volatile oil prices. Dividend history should be high on your checklist when evaluating a company.

5. Stability

Most individual investors are vulnerable to their emotions. When markets are rising, that’s usually not an issue unless it leads to dangerous moves like leveraging. In down markets, it’s another story. Watching your bottom line drop month after month can result in growing anxiety, which can culminate in bad investing decisions. If you’re at all prone to this affliction, avoid high-beta stocks – those with a history of larger price swings than the broad market. Of course, low beta stocks can lose value in a declining market. But the damage, and the resulting shock, will be much less than if your portfolio is crammed with shares whose chart resembles the Alps.

6. Balance sheet

Most people overlook the balance sheet when researching a company. The reason is simple: unless you took commerce in college, understanding them isn’t easy. But if you do nothing else, look at the long-term debt line. How much does the company owe? 

Investopedia says the debt/equity ratio (d/e) is one of the most important corporate valuation metrics because it highlights a company’s dependence on borrowed funds and its ability to meet its financial obligations. The less dependent a company is on debt, the less the risk it would be forced into bankruptcy. Investopedia says the ideal d/e ratio should not exceed 2.0, which means two-thirds of a company’s capital is financed from debt and a third from equity.

Occasionally you’ll come across a company that is debt free. That’s not necessarily a good thing, because it means the firm is not leveraging its borrowing power to expand the business. But it certainly means less risk.

That’s my list. Few stocks will tick all the boxes – for example, utilities and REITs are likely to have high d/e ratios because they are very capital intensive. That’s one reason they are losing ground in a rising rate environment. If you understand the reason behind potential problems, you’ll be better equipped to deal with them and make informed decisions if they arise.

Gordon Pape is Editor and Publisher of the Internet Wealth Builder and Income Investor newsletters. For more information and details on how to subscribe, go to www.buildingwealth.ca/subscribe

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