5 Key Things I Need to Understand Before Investing in a Company
#30 A Young Professionals Weekly Investing Insights
Losing money sucks.
And I have definitely felt the sting of a bad investment.
So how can one avoid those mistakes and pick the right stocks with confidence?
In this article, I’ll share the five crucial things you need to know about a business before you invest.
By the end, you'll have a solid framework to evaluate any company and make smarter, more informed investment decisions.
Let's dive in.
1. How Does the Company Make Money? (Business Model and Revenue Streams)
Think of a company's business model as its game plan for making money.
Here's what you need to look at:
Main revenue sources:
Is the company selling products, services, or both?
For example, Apple makes money from selling iPhones (products) and Apple Music subscriptions (services).
Revenue diversity:
Does the company rely on one main product, or does it have multiple income streams?
A company with diverse revenue sources is often more stable.
Scalability:
Can the company easily grow its business without massive new investments?
Software companies often scale well because they can sell to more customers without huge additional costs.
Sustainability:
Is this a business that can keep making money for years to come, or is it a passing trend?
A quick tip: Look for companies with easy-to-understand business models. If you can't figure out how a company makes money, its probably too risky.
What Makes This Company Special? (Competitive Advantage or "Moat")
A competitive advantage is like a company's superpower.
It's what helps them stay ahead of competitors.
Here are some types to look for:
Brand power: Think Coca-Cola or Nike. People pay more for these brands because they trust and like them.
Patents: These give a company the exclusive right to sell certain products. For example, pharmaceutical companies rely heavily on patents.
Network effects: The more people use a product, the more valuable it becomes. Instagram is a great example – it's valuable because all your friends are on it.
Switching costs: If it's hard or expensive for customers to switch to a competitor, that's a big advantage. Think about how hard it is to switch banks – that's a switching cost.
Ask yourself: Is this advantage likely to last for years, or can competitors easily copy it?
Is the Company Financially Healthy? (Financial Health and Performance)
This is where we look at the numbers.
And don't worry - you don't need to be a math genius.
Here are the key things to check:
Revenue growth: Is the company selling more each year?
Look for steady growth.Profit margins: Out of every dollar of sales, how much does the company keep as profit?
Higher is generally better.Debt levels: Too much debt can be risky.
Compare the company's debt to others in the same industry.Cash flow: Is the company bringing in more cash than it's spending?
Positive cash flow is crucial.
Quick tip: Look at these numbers over at least 5 years. Are they getting better or worse?
Also, compare them to other companies in the same industry.
Who's Running the Show? (Management Quality and Corporate Governance)
The people leading the company are super important.
Here's what to consider:
Track record: Has the leadership team successfully grown companies before?
Skin in the game: Do the leaders own a significant amount of company stock? This aligns their interests with shareholders.
Communication: Do they clearly explain the company's performance and plans to investors?
Red flags: Watch out for things like frequent leadership changes or accounting scandals.
Remember: Great leaders can turn an average company into a star performer, while poor leadership can ruin even the best business.
What's Happening in the Big Picture? (Industry Dynamics and Market Position)
No company exists in a vacuum.
Understanding the broader context is crucial:
Market size and growth: How big is the market the company operates in? Is it growing?
Market share: What percentage of the market does the company control? Is this percentage increasing?
Competitive landscape: Who are the main competitors? How does our company stack up against them?
Regulations: Are there any laws or regulations that could help or hurt the company?
Disruption potential: Could new technologies or business models shake up the industry?
Bonus: Future Growth Prospects
While you're at it, try to get a sense of where the company is headed:
New products or services in development
Plans to expand into new countries or markets
How the company is adapting to industry trends
Putting It All Together
When you're done looking at these five areas, you should have a pretty good picture of the company.
Ask yourself:
Do I understand how this company works and makes money?
Does it have strong advantages over competitors?
Is it financially healthy and growing?
Do I trust the leadership team?
Is the company well-positioned in its industry?
If you can answer "yes" to most of these questions, you might have found a good investment opportunity.
No company is perfect, but understanding these key areas will help you make smarter investment decisions.
One thing you should keep in mind is that this process takes time and practice.
I sometimes get discouraged - so will you most likely - because it can be overwhelming at first.
The thing is, the more companies you analyse, the better you'll get at spotting the winners (and avoiding the losers).
So keep on learning :)
Thanks for reading.
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This newsletter is for informational purposes only and is not intended as financial advice. The insights provided are illustrative and should not be the sole basis for investment decisions. Readers should conduct their own research and consult professional advisors before investing. The authors and publishers are not liable for any financial losses resulting from actions taken based on this content. Investing in the stock market involves risk, including potential loss of capital.
Great advice! Thank you.
I enjoyed every bit of it. I also have started my newsletter on personal finance. Would like to get your thoughts on them as well. Once again absolutely top notch advices here.