Before you buy a stock, there are three questions that you need to answer. Too many people buy stocks based on price alone or a gut-feeling. You should look beyond the price or the hot tip to the company behind the stock.
You may think that it doesn't matter that much -- you are a long term investor. However, it never hurts to choose your investments wisely. You need every stock in your portfolio to perform well. Otherwise, you are losing your future money.
Ask yourself the following questions before you purchase a stock:
Question Number One: What does this company do?
You need to be able to explain what this company does in a few sentences. Pretend that you are explaining it to your spouse or a teenager. They should understand the company after you describe it.
You don't have to know how they do what they do to explain what they do. For example, you don't need to know how to program computer operating systems to explain that a company makes computer software and hardware work in together. One more sentence, and you've just explained Microsoft.
Some companies have more difficult business models. But there are plenty of companies out there that are simple and offer great investment potential. Things don't need to be complicated to make money.
Question Number Two: Is the company growing?
You want to see a growth in earnings, a sustained growth history and revenue growth. Many investors overlook revenue, but it is fairly important. If revenue isn't growing faster or at the same pace as earnings, you need to research why. It could be a sign of decreasing earnings in the future.
Increasing revenue and declining earnings can be indicative of several situations. The company could be rolling out a new product line or entering a new market. Or, the management could be having trouble. Perhaps the company can't really compete and be profitable.
You have to do the research and see what the growth is and why it is. There is more to a stock than just a few numbers, you have to get the entire picture.
Question Number Three: What will you pay?
You've done a lot of research. The company looks pretty good, so you may be eager to go ahead and buy the stock. But you need to make sure that the stock isn't trading for more than it is really worth. It could be near a high point or riding on a hot market. You need to know where the stock price should be.
If the actual price of the stock is higher than where it should be, you would benefit from a little patience. Wait until it corrects itself before you buy. Watch the market for a bad day when everything is down. Sometimes industry news will affect an entire sector. The goal is to find a low entry point.
If the stock is much lower than you anticipated it would be, it might be a good time to buy. But you should try to find a reason why the price is under its true value. You may not find one, but it doesn't hurt to look at the company one more time. It may be that things have changed and your analysis is off. It is better to walk away than to take a loss.
When looking at a stock, you need to take a good hard look at the company behind it. Ask yourself the questions above to see if the stock is the right stock for you. Don't be afraid to take a second look if necessary. It is better to be sure than to lose money.
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