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5 things you must know before buying stocks

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In 35 years of investing in stocks and shares, I’ve made every howler possible. However, I’ve learnt over decades how to control my animal spirits and invest sensibly long term. Now when I analyse a company, I try to find reasons not to buy its stock. Also, when hunting for top shares to buy, I must know five very important things about each stock before making buying decisions. Here they are.

What’s the company’s history?

Acclaimed US fund manager Peter Lynch once remarked, “Although it’s easy to forget sometimes, a share is not a lottery ticket…it’s part-ownership of a business”. Nowadays, I realise that I’m not buying stocks as such. Instead, I’m buying into businesses. Hence, I learn all about a company’s history, operations, products, and how it makes money. And if I don’t like the look of a business, then I don’t buy its shares. It’s that simple.

How much debt is the company carrying?

The second thing I must know is how much net debt a company is carrying on its balance sheet. To me, debt is like risk: the more debt a corporation has, the more risky its stock is. Right now, interest rates are close to record lows, so corporate debt is mostly dirt-cheap. But with interest rates set to rise in the US and UK, this low-cost debt could become a high-risk burden. Therefore, I tend to avoid stocks of companies with eye-watering levels of borrowing.

How highly valued are the company’s earnings?

Next I establish how ‘cheap’ or ‘expensive’ stocks are. To do this, I check the price-to-earnings ratio (P/E). This is found by dividing a stock’s current share price by its earnings per share (EPS). For example, a share costing £1 with EPS of 8p has a P/E of 100/8 = 12.5. So-called value shares tend to have low P/Es, while go-go growth shares (such as US tech stocks) often trade on double- or even triple-digit ratings. But P/Es vary widely across companies, sectors, industries, and countries. Thus, I make a judgement about the relative P/E rating of a stock before deciding whether it is worth buying or not.

Does this stock pay dividends?

I’m a huge fan of dividends — the regular cash payments paid by companies to shareholders. Typically, these are paid half-yearly or quarterly. But dividends are not guaranteed, so they can be cut or cancelled at any time. What’s more, not all stocks pay dividends. For example, in the UK FTSE 100 index, at least 11 of the 101 stocks (one company has dual-listed shares) don’t pay dividends. In the UK, reinvested dividends can account for up to half of long-term returns from shares. That’s why I’m a keen buyer of high-yielding FTSE 100 shares.

How volatile is this stock?

Stocks don’t tend to move in straight lines. They zigzag up and down, sometimes oscillating wildly. To see a share’s past price action, I check its 52-week range. For example, I own shares in pharma giant GlaxoSmithKline (GSK). Over the past year, this share has fluctuated between a low of 1,190.80p (on 26 February 2021) and a high of 1,628.78p (on 30 December 2021). The current share price is 1,586.8p, so GSK is within 2.6% of its year high. I’m glad I didn’t sell below £12 — and I’ll keep holding my GSK shares for now!

The post 5 things you must know before buying stocks appeared first on The Motley Fool UK.

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Cliffdarcy owns shares of GlaxoSmithKline. The Motley Fool UK has recommended GlaxoSmithKline. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services, such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a diverse range of insights makes us better investors.