Many individuals buy shares on a whim, usually because a stock is being put on a trend or a financial guru suggests the stock. We rarely have time to sit down and study stocks all day so we might buy impulsively. If you want someone who does analyse stocks full-time to help you, you might consider working with a financial advisor.

Whatever happens, you have to understand the fundamentals of what you are investing in. Investing always comes with some risk, but knowing what to ask can help make your portfolio less likely to have big ups and downs.

When contemplating the purchase of your next stock, consider the following ten questions.

 1. Is the Company Financially Healthy?

The financial health of a company can be assessed through its balance sheet, income statement and cash-flow statement. The Balance Sheet provides a snapshot of assets, liabilities and shareholder’s equity which reveals debt level, short-term liquidity and asset structure of the company. An Income Statement tracks revenue, expenses and profits over time and provides information regarding the trend in revenue growth, profitability and reinvestment. The Cash flow Statement focuses on the actual cash movement, categorizing activities into operations, investing and financing, which reveals vital information about liquidity, cash generation and overall trends in cash.

   2. Have I Calculated the Valuation of the Stock?

 Calculating the valuation of a stock involves determining its intrinsic value to evaluate whether it is overpriced, fairly priced, or priced compared to its market price. An investor must trust the valuation of a stock by judging multiple fundamental metrics, such as EPS, P/E ratio, P/B ratio, Debt/Equity ratio, Interest Coverage Ratio, etc.

The Earnings Per Share (EPS) measures a company’s profitability per share. The Price-to-earnings (P/E) ratio is measured by dividing the current market price of a stock by its earnings per share. It is used to analyse if the company is overvalued or undervalued compared to its industry peers.

A company’s Book Value represents the net value of a company's assets as recorded in its financial statements. It is calculated by subtracting the company's total liabilities from its total assets. The Price-to-book value (P/B) ratio compares a company’s stock price to its book value, which is used to estimate the potential returns to the investors if the company gets delisted.

The EV/EBITDA method uses the company's EBITDA multiplied by the industry average EV/EBITDA ratio to estimate enterprise value. Finally, the PEG Ratio adjusts the P/E ratio for growth and the PEG ratio below 1 the stock may be undervalued when factoring in growth.

Also, there are Discounted Cash Flow (DCF) method that Estimates intrinsic value by calculating the present value of future cash flows, adjusted for risk. The Earnings Capitalization Method is a valuation approach used to estimate a company's worth based on its expected future earnings. Also, there is a Dividend Discount Model (DDM) that is used to value dividend-paying stocks based on the present value of their expected future dividends.

   3. What is the Company's debt-to-equity ratio and its cash-to-debt ratio?

Both these ratios provide insight into a company’s capital structure and its ability to manage debt. The debt-to-equity (solvency) ratio compares a company’s total debt to its shareholders' indicating how much debt a company uses to finance its operations relative to its equity. A high D/E ratio may signal increased financial risk, especially during economic downturns. The cash-to-debt ratio measures a company’s ability to repay its debt using its available cash. The higher the ratio, the better it is since cash can cover the debt payable in case of a situation decreasing financial risk.

While the D/E and cash-to-debt ratios examine overall debt levels and liquidity, the interest coverage ratio gives an idea of whether the company's earnings are adequate to cover the cost of its ongoing debt. This is particularly useful when evaluating financial risk.

   4. What is the Company’s Return on Invested Capital?

The Return on Invested Capital, or ROIC, is one of the profitability metrics that evaluate how effectively a company is using its capital to produce profits. A comparison of ROIC with the cost of capital allows investors to know whether the company is creating or destroying value. An average ROIC of 15% or more often indicates effective management and competitive advantage, as well as the possibility of long-term growth and the creation of shareholder value. However, it can vary as some sectors may have low ROIC.

Comparing it to ROA (measures how well assets earn profits) and ROE (measures profitability in relation to shareholders’ equity) gives a well-rounded view of profitability, equity and asset management effectiveness.

   5. Is Management Competent and Shareholder-oriented?

The effectiveness of a company’s management significantly impacts its success. Investors should review management’s track record, including the history of consistent growth, crisis management, and effective strategy execution. Determine whether management is allocating capital back into growth opportunities for long-term value creation, paying down debt, or returning it to shareholders in the form of dividends and buybacks. High insider ownership sometimes indicates a vested interest in the company’s success.
Also, the management’s adherence to ethical practices, handling of conflicts of interest, and transparency in communication to its shareholders such as clear and honest disclosure in annual reports are key aspects that need to be reviewed by an investor.

   6. How Well Do Reported Earnings Convert to Cash Flow?

 Understanding how well a company's reported earnings convert to cash flow is crucial for investors. This conversion indicates the actual cash available for operations, investments, and dividends, as reported earnings can sometimes be misleading due to accounting practices. Compare the net income from the income statement with the operating cash flow from the cash flow statement. Strong cash flow indicates the company can fund operations, invest in growth, meet obligations and pay dividends. Investors should be cautious of high reported earnings but poor cash flow as it indicates an issue in the company's health. Also, there should be industry-specific considerations as sometimes low cash flow might be due to reinvestment. Additionally, liquidity ratios (current and quick ratios) can provide further insight into a company's ability to meet short-term obligations, especially when cash flow is low due to reinvestment.

   7. How do Profits Respond to Changes in Revenue?

Understanding the relationship between revenue and profit is important for assessing a company’s financial stability. To understand how profits react to changes in revenues, analyse operating leverage (proportion of fixed costs), profitability ratios (gross and net profit margin) and efficiency ratios (asset turnover and inventory turnover ratio). Improving margins, higher asset turnover and effective inventory management with revenue suggest cost and operational efficiency. Companies with high fixed costs may experience significant profit fluctuations with changes in sales.

   8. What Would be the Purpose of This Stock for My Portfolio?

The purpose of a stock in your portfolio should depend on your risk tolerance, investment goals and overall strategy. The idea is to choose the kind of stock that brings in growth when you look to appreciate your capital or select dividend-paying stocks offering a regular income when you desire earnings. To diversify the portfolio choosing stocks under different sectors can significantly minimise the risk.

   9. When Should I Invest?

Timing can significantly impact investment returns. Economic indicators such as interest rate, inflation, employment rate and market conditions may affect stock prices. Investing early is preferable as time in the market tends to outweigh timing in the market. However, for retail investors, timing the market is often impractical due to the unpredictability of stock prices. Instead, rupee cost averaging through systematic investment plans (SIPs) is a smarter approach where equal amounts are invested periodically. In the case of equity, rupee cost averaging is obtained by value averaging, which is buying more shares at lower prices and buying fewer shares when the market price rises.

Always assessing risk tolerance, investing horizon, financial stability, not making emotional investment decisions and consulting a financial investor before investing is the cornerstone of success. Start early, stay consistent, and align investments with your goals.

  10. How Much Should I Invest?

The sum to invest depends on the set financial goals, risk appetite, and current situation. Make sure you have a good emergency fund in place (3-6 months of expenses) before investing. Review your disposable income based on your budget and define your investment goals and their timing according to importance, such as retirement or buying a house. Diversify across asset classes to manage risk. Start with an amount that you are comfortable with and increase gradually as you become confident with your strategy.

Investors should have answers to these ten questions before investing in the stock to enable them to make good investment decisions that meet their financial needs. Careful observation of the competitive environment of a company, the quality of its management, its health, and the measures taken for valuation can help investors discover new opportunities while minimising the risks associated with the stock market. Ultimately, better fund selection and a greater assurance of your choices in investing will result from putting forth the effort to answer those key questions and, more importantly, doing so at the right time.

-Sukalyan Haldar & Marifur Rahaman