Fundamentals for Purchasing a Stock

by Megan Martin

If you're a beginning investor in the stock market, you may be overwhelmed by the number of stock options available to you. Buying individual stocks can be a risky business, but knowing what to look for can help. If you're just getting started, consider building your portfolio by investing in low-risk, lower-cost mutual funds before you start investing in individual stocks. When you have a diversified portfolio together, make the shift to investing in individual stocks.

Ignore the Hype

A lot of hype can surround certain types of stocks, particularly in the form of analyst recommendations. While the buzz may be persuasive, it's not always in your best interest to pick a stock based on its trendiness. Analysts typically have good advice on whether a business is healthy or not, but tend to focus on what to buy in the moment, which can cause problems in the long term. To narrow your choices, consider buying stock in an industry or company you support, have experience with or simply feel comfortable with.

Evaluate the Company's Track Record

Buying a stock means that you are essentially the owner of part of a company, so you want to choose a company that is financially healthy. The first step to determining this is to look into a company's earnings or profitability by reviewing its annual or quarterly financial reports which are available online. Look at the big picture: just because a company did well last quarter doesn't mean that this will always be the case. One strong indicator of financial health is long-term revenue growth, which is indicated by growing stock prices. Also look at the profit margin, or revenue versus expenses. If a company is keeping expenses down and increasing revenue, this is a good sign. It is also important to investigate the company's debt. As you review individual companies, compare how much debt each has with the others. Companies with more debt will obviously spend more money on paying back what they owe than investing in expanding the business. Finally, if the company pays cash dividends to investors and these dividends consistently increase, this is a good indication.

Understand the Price Earnings Ratio

The price to earnings ratio, also known as the P/E, shows how much stockholders pay for every dollar the company brings in. You can arrive at this number if you divide the share price by the net income of the company. For example, if a stock sells for $30 a share and has a $2 net income, the P/E is 15. If the price to earnings ratio is greater than 20, the stock is deemed expensive; under 15 and it is considered cheap. Ideally, you want to invest in stocks with a lower P/E because you are getting more value for your dollar. But make sure you investigate why a stock is cheap, as it can be an indication that the company isn't growing. If this is a consistent trend, you will not make much on the stock. Also keep in mind that a fast-growing company's stock prices may be higher, but you're likely to make more money on it quickly.

Final Considerations

If a stock seems volatile or unpredictable, this is not necessarily a terrible indication: individual stocks are simply less predictable than mutual funds, but can also offer higher payouts. Check back to see how the stock has performed over the last year as you make your decision. Finally, after you buy a stock make a plan for selling. Set a low and high price point for each stock; if its price falls below your low or rises above your high, plan to sell. Throughout the process, talk to a trusted expert if possible to help you guide your decisions.

Photo Credits

  • Comstock Images/Comstock/Getty Images