Buying stock gives you an ownership stake in a publicly traded company. If the stock price goes up and you sell your shares for more than you paid for them, you'll net a profit if those gains outweigh your tax liability. The opposite is also true—you could lose money if you sell while prices are lower than what you paid.
You might be wondering how to research stocks so that you buy the right ones. The truth is that it isn't an exact science. The stock market is full of unknowns, but doing a little digging on the front end can help you choose stocks that complement your investment portfolio. Here are five simple steps to research a stock.
1. Learn Different Types of Stock Analysis
There are a couple of different ways to analyze stocks (also known as equities). Each approach tries to make the best guess as to whether a stock will perform well in the future.
This approach focuses on things like company performance, economic conditions and industry trends to determine if a stock is poised for growth. For example, if the company's balance sheet is strong and it seems to have a competitive edge over other companies, those could be good signs. Fundamental analysis is often used for buy-and-hold investments.
This uses nitty-gritty stock market indicators to identify sectors that have the best potential for growth. You then zero in on attractive stocks within those sectors. It involves charting the stock's price history and volume (how many shares are currently trading). The goal is to look for patterns that might indicate future spikes—like upward price trends.
Technical analysis is, well, more technical, which may be intimidating to new investors. It's typically used for short-term investments. Just keep in mind that short-term capital gains are taxed at a higher rate than long-term gains.
2. Understand Key Performance Metrics
When you research a stock, the following metrics may prove valuable. Just remember that market volatility is part of the journey. Some stocks and asset classes actually perform better during rocky times. When researching stocks, look back on how they've weathered previous storms.
- Earnings per share: The company's net profit divided by the number of its outstanding common stock shares. It's a snapshot of how much the company actually earns per stock share. Net profit is the amount of money taken in after paying out all business expenses. You can find this figure on the company's latest income statement.
- Price-to-earnings (P/E) ratio: Divides the current stock price by its per-share earnings. If you find that a stock's P/E ratio is lower than its competitors, it suggests that the stock might be undervalued.
- Return on equity (ROE): Subtract the company's liabilities from its assets, then divide its net income by that number. If the final percentage is higher than its competitors, it suggests that the company has the financial muscle to maintain its profits—and hopefully exceed them.
- The company's operating revenue: Is the company profitable? Take a look at its most recent income statements to see how much gross revenue it's bringing in on a regular basis. If that number is on a decline, it could be a red flag.
- Average trading price: When you zoom out and look at the stock price over a period of time, do any trends emerge? If it's been steadily ticking upward for some time, that could indicate the stock has momentum. This is the idea behind growth investing.
3. Learn About the Company
Stock investing isn't just about performance metrics. Learning about the company itself can help you choose stocks that are in line with your values, a strategy known as socially responsible investing. With this approach, ideal investments are ones that support your values and have potential financial returns. You might focus on companies that excel in terms of environmental sustainability, social consciousness or corporate governance. Some other factors to look at might include:
- The company's owner: Do you agree with their business decisions and the direction they're taking the organization? Do they give back to the community?
- The company culture: Reading headlines about a company's toxic work culture or inequality issues might deter you from investing. Do they value their employees and prioritize diversity and inclusion? Similarly, are they committed to ethical business practices?
- The company's values: What's the company's long-term vision? If it resonates with your values and passions, it might also fit into your investment portfolio. For example, a company that helps empower underserved communities might feel meaningful to you.
4. Know Your Risk Tolerance
Market volatility tends to push stock prices up and down. All sorts of factors can influence the stock market, including the economy, global politics, domestic political issues, industry shake-ups and more. That's what makes stock investing inherently risky—no investor can accurately predict future market conditions.
Your personal risk tolerance will come into play when you research a stock. While high-risk stocks can offer potentially large returns, you're also vulnerable to significant losses. Diversifying your portfolio with a combination of high- and low-risk investments is one way to mitigate risk. Before you go all-in on that new tech company you've got a good feeling about, be sure your portfolio has some stable investments too. That might be bonds, high-yield savings accounts, money market accounts or certificates of deposit (CDs).
There are ways to invest in stocks that aren't quite as risky as individual stock picking. Mutual funds and exchange-traded funds (ETFs) both provide built-in diversification. They allow you to buy small shares of various securities, like a mix of stocks and bonds or a collection of different stocks.
5. Put It All Together
Think about which stock analysis strategies and performance metrics speak to you most. Now see if you can integrate them with your values and risk tolerance. When taken together, it can help you settle on an investment strategy that feels right for you. That might be:
- Buy and hold: Looking for investments you hope will increase in value over a longer time period.
- Growth investing: Focusing on stocks you think will continue to perform well based on past performance.
- Value investing: Investing in stocks you believe are currently undervalued. With time, stock prices will hopefully rise.
- Passive investing: Taking a more hands-off approach, like investing in index funds. These are low-cost ETFs or mutual funds that track a specific market index, sector or investment trend.
The Bottom Line
Impulsive stock picking probably isn't the best way to grow your wealth. Doing your research can help you choose stocks that are better aligned with your risk tolerance and investment goals.