Doing a bit of research before buying any stock is essential if you want to generate strong returns from the stock market. As Warren Buffett – the greatest investor of all time – says: “Risk comes from not knowing what you’re doing.” With that quote in mind, here are five basic questions I think it’s important to ask before buying any FTSE 100 stock.
Will it outperform the index?
This is a great question to start with and one my colleague Paul Summers covered in more detail recently. Essentially, if you don’t think a FTSE 100 stock will actually outperform the FTSE 100 index over your designated investment horizon, there’s not much point in investing in it, is there? Not when you can easily just buy a FTSE 100 tracker fund these days. If you’re buying individual stocks, you should really only be looking at the companies you believe offer index-outperformance potential.
Will the company be bigger in five/10 years?
This is another excellent ‘big picture’ question to ask. To borrow another quote from Buffett: “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, 10 and 20 years from now.”
It’s important to consider business threats and technological disruption. Does the company have an economic moat that can prevent competitors from stealing market share? By finding companies that have a bright future and a competitive advantage, you give yourself a better chance of investor success.
Is it a profitable company?
Next, look at the profitability of the company. Companies that can consistently generate high levels of profitability tend to generate excellent returns for investors over time.
You can analyse profitability by looking at return on equity (ROE) or return on capital employed (ROCE) ratios. These will tell you how effective management is at generating profits. Generally speaking, a ratio of 15 or higher is good. Also, look for consistency here.
Does it have a lot of debt?
It’s also important to consider the financial strength of the company and look at how much debt is on the balance sheet. While debt can help companies achieve their goals during the good times, it can also be a real problem during periods of financial stress. So the less debt, the better. A good ratio to check in this regard is the debt-to-equity ratio. Here, Warren Buffett generally likes to see a ratio of less than 50%.
Is the valuation fair?
Finally, it’s worth asking whether the valuation of the company is reasonable. There’s a rule of thumb that a P/E ratio over 15 is expensive while a P/E under 15 is cheap. However, personally, I think this rule is too simplistic.
While valuation is important, I think you’re better off paying a slightly higher price for a high-quality stock (i.e. one that ticks all the boxes above) than picking a low-quality stock just because it’s cheap. I agree with Buffett when he says: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Of course, these are just five basic questions. There are many more you could ask. If you’re looking to learn more about investing basics, you’ve come to the right place…
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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.