What to Know Before Buying Stock
Before buying a stock, investors should know about certain aspects of the company's business fundamentals, as well as the stock's market valuation. A stock may not see sustainable price increase over time without consistent growth of its company's business. A company of sound business fundamentals may be a good stock, but it may not be a good investment for the potential buyer if investment returns are reduced by increased investment costs because of high market valuation.
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Business Growth
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Before buying a stock, investors should know if the company has been growing in terms of both sales and earnings. When many companies compete in the same market, a company's increased sales over time may be a good indication that the company likely has gained market shares from its competitors. However, sales alone don't reveal whether a company is profitable. Sales with high production cost or low sales price may lead to money losses. Earnings are another important business fundamental for evaluating potential investment returns when buying a stock.
Cash Flow
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A stock's value is ultimately decided by the amount of cash flow the company is able to generate. Cash flows are different from earnings, or net income, which are accounting terms that allow the inclusion of non-cash items. For example, different asset depreciation policies could artificially increase or decrease earnings, but would not change the cash-flow situation. Also, any markup in the value of a company's certain investment assets for unrealized gains would increase earnings accordingly but without adding any cash flow. Knowing about a company's ability to generate cash flows from operations is an important factor to consider when deciding buying a stock.
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Debt Uses
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Despite the importance of cash flows from operations, they can also be misleading if not further investigated. Operating cash flows may become severely incumbent if a company incurs too much debt. Absent any refinancing effort, a company would have to make interest payments and eventually repayments of debt principals out of the cash earned from operations. Thus, initial operating cash flows may not be all available to a company's shareholders, which would discount any value assessment of the stock. If a company is able to achieve the same level of growth and cash flows without resorting to debt, its stock should be more valuable than stocks of other companies that use debt.
Market Valuation
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Before buying a stock, investors should also know if the stock is overvalued even if it has sound business fundamentals. Buying a good company doesn't always make a good investment if the price paid is too high relative to its stock's true, intrinsic value. To assess how the market is valuing a stock, investors may apply the so-called market multiple analysis using either the price-to-earnings ratio or any of the other multiples such as the price-to-book ratio. A ratio of a stock's price divided by its earnings can be used for comparisons to those of similar companies to see if a stock is overvalued or undervalued.
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