For many first-time investors, deciding when to purchase a stock can seem like a simple task. But making the right investing moves for the long term can be more complicated.
When to buy your first stock hinges on why you want to buy it, says Derek Hoyt, chief investment officer at BerganKDV Wealth Management in Bloomington, Minnesota.
“Buying a single stock is not the way to go to start investing,” Hoyt says. “When you buy a single stock you are exposing yourself to individual business risk because you are concentrated in one single business. That’s different than buying a diversified fund that tracks the S&P 500.”
[See: 9 Psychological Biases That Hurt Investors.]
Instead, Hoyt recommends investors buy stocks once they’re investing in a more diversified manner via their 401(k) or other investment accounts.
Still, he cautions that it’s important to be diversified and not overinvested in any one company or industry.
“You can think you have the best stock in the world, but as we’ve seen time and again, conditions change and investor attitudes change,” Hoyt says. “You never know when and how it’s going to happen.”
When an investor is ready to buy individual securities, start by asking, “How long am I going to own this stock?” says Dale Horn, senior vice president at UBS Financial Services in Baltimore. “Time is important.”
If it’s a stock in a new technology such as a company focused on the cybersecurity industry, or a rapid growth company such as an Amazon.com (ticker: AMZN), Horn says investors may not want to own it that long.
Then there are blue-chip stalwarts that make the Dow Jones industrial average, also known as the “Dow 30,” such as Apple ( AAPL), General Electric Co. ( GE) and Johnson & Johnson ( JNJ) that includes many conservative and consistent old-school companies.
Investors should also consider how much any stock purchase represents their total investible assets, Horn says.
“You don’t want a company dominating your portfolio,” Horn says. “A lot of people, when they are first starting out, don’t realize the risk of buying just one or two companies because you never know what can change.”
On the flip side, Hoyt says, even if investors buy a mutual fund or exchange-traded fund within a diversified portfolio, most will only own 1 to 2 percent of a particular stock within the holding.
“The vast majority are going to own Apple, but that doesn’t preclude anyone from going out and buying more,” he says.
[See: 13 Ways to Take the Emotions Out of Investing.]
Invest in what you know. It helps to have some pre-existing knowledge of a company or and industry before investing in it. “Keep it simple and invest in something you know,” Hoyt says. “Find a quality stock you’ve heard of and know how the company operates.”
Dig into key components of the stock. Investors should look at a company’s relative value, growth in revenue and profitability. “That’s what we look at when we are buying stock,” Hoyt says.
Start by reviewing a company’s relative value within the broader overall market and how a company has done within its industry, Hoyt says. The most common way to do this is by reviewing a security’s price-earnings ratio, Hoyt says, which is based on the past four quarters — a trailing 12 month cycle — of reported earnings.
Experts say the ratio indicates how much investors are willing to pay for a stock relative to the company’s earnings.
For example, say Apple is trading at $115.82. That number is then divided by the earnings per share, also called EPS, at $8.31, which equals a P/E of $13.94. That means investors are willing to pay $13.94 for every dollar of earnings Apple has.
“Smaller numbers are better,” Hoyt says. “Because you are dividing the price by the amount of earnings the company generates, the smaller the number, the less you are paying for the stock. Right now, Apple is cheaper than the overall market.”
It’s also important to look at other benchmarks related to price including price-book ratio, which compares the value of a stock’s value to its last quarter book value — its hard tangible assets. This varies from industry to industry, where a company with factories will have more of these assets than say a Facebook ( FB), Hoyt says. He also recommends looking at a company’s price-cash flow ratio, a profitability metric that helps determine if a company has a higher cash flow.
The other important metric is the price-sales ratio, which looks at “how much revenue is coming in the door and how much are you paying for it,” Hoyt says.
“Look at all the four metrics and compare them to a benchmark like S&P 500 for a more complete picture,” Hoyt says.
[See: 7 Ways to Tell if a Stock is a Good Price.]
Review overall profitability and earnings growth. “Profitability looks at how efficient the company utilize its resources,” Hoyt says. “Let’s say they sell a ton of goods but aren’t keeping expenses down, their net income is going to be low and what they get to keep is less. Even though price-to-sales can be good, a company’s price-to-earnings can be bad.”
Hoyt also says investors should look at a security’s return on equity, net margins and return on assets. “The higher the number the better, because that means they are running an efficient business,” he says.
For example, Apple’s return on equity is 34.4 percent. “That’s really good,” he says. “Return on equity of 15 or more is typically a good number and the net margins on Apple are 21 percent because they do a good job of translating those earning into profit.”
Hoyt says any net margin usually above 8 to 10 percent, depending on the industry, is an indication the company could potentially be a good investment.
Investors should also look at the earnings-per-share trend.
“Is it stagnant, is it growing, or is it declining,” Hoyt says. “You want to buy a company with strong market position that helps them over time to expand that market share and grow their earnings.”
Other advice. Avoid what Greg Casper, financial advisor and partner at The Financial Group in Sheboygan, Wisconsin, calls “the herd mentality” after an investor hears that a certain stock is a good investment right now and the decision is based on others investing in it.
“You’re putting your faith with the investment decision based on others without doing any individual due diligence,” Casper says.
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How to Buy Your First Stock originally appeared on usnews.com
