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The best companies to buy stock in are those most likely to grow.

Key points

  • Doing your homework is an essential part of investing with confidence.
  • Most of what you need to know is contained in a company’s prospectus.
  • Because you’re investing for the long term, the goal is to find companies with plenty of growth potential.

When you purchase stock in a specific business, your fortunes rise and fall on how well that business does. On the other hand, when you invest in a 401(k), Roth IRA, or other retirement vehicle, fund managers typically invest in different financial products (including stock), diffusing your risk of losing it all.

That said, if you want to invest in a particular business, make sure to do your homework first.

Here’s what to look for.

The prospectus

When a company offers stock to investors, a prospectus must be filed with the U.S. Securities and Exchange Commission (SEC). A prospectus provides the information you need to determine whether that stock is a suitable investment for you.

While a preliminary prospectus is provided when a company first begins to offer stock, the final prospectus provides more detailed information. A final prospectus typical contains the following information:

  • A summary of the company, including its age, principals, management experience, and how active management is in the business.
  • Number of shares to be issued
  • Offering price
  • Company financial data
  • Risk factors
  • How proceeds will be used
  • Dividend policy
  • Type of securities offered
  • Who is underwriting the company

Focus on these eight factors

1. Earnings growth

Look for trends. Over time, have earnings generally increased, and have those earnings been steady?

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2. Competition

How does the company compare with the overall industry? For example, if the company makes biofuel, how does it rank against competitors also making biofuel? Does it constantly lag, or can it keep up with the competition? It’s essential to bet on a company that has found its footing among competitors.

3. Stability

All companies go through ups and downs. It’s not surprising for a company’s growth to slow during a bear market. If the company’s down times have occurred when the rest of the market is down, it’s not a red flag. But if the business fluctuates like a yo-yo, that could spell trouble.

4. Management

Does management ensure that the company stays on the cutting edge of innovation, or does it follow the trends set by other businesses in its industry? What can you learn about the reputation of those in management positions? A Google search can help you paint a picture. If the current CEO ran their last company into the ground, it would be wise to worry they’ll do it again.

5. Debt-to-equity ratio

Every company has a balance sheet and carries some debt. However, you want to determine how much debt the company carries compared to its equity. In short, you want the business to have more assets than liabilities.

6. Price-to-earnings (P/E) ratio

In a nutshell, a P/E ratio compares the company’s current price to its per-share earnings. Here’s how that works: Let’s say the earnings per share are $2, and the company is trading at $30. That means the P/E is 15. The higher the P/E ratio, the better.

Some people believe that the P/E ratio is the most critical factor to consider before purchasing stock, but it only tells part of the story. Look at the competitor’s P/E ratios. Are they higher or lower?

7. Dividends

It’s typically a stable company that pays dividends; however, that comes with a caveat. If a company’s dividends seem too high, it may be because it’s not reinvesting enough back into the business. The sweet spot is when a company pays modest (but increasing) dividends.

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8. Scalability

Does the company have room for growth? A company that grows over time helps ensure you’ve made an investment you’ll want to hold onto.

There are no sure things in life, and this includes investments. Still, taking the time to thoroughly investigate a business before investing increases your odds of success.

About the Author

Dana has been writing about personal finance for more than 20 years, specializing in loans, debt management, investments, and business.

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