How to evaluate companies when buying stock

Before you buy stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition in a company, it’s a good idea to evaluate whether it seems like the right investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition for you. A company’s stock price is often the first thing investors notice. But there are other ways you can estimate the value of a business. You’ll want to consider both financial and non-financial factors. Learn more about how to evaluate companies before investing.

On this page we answer:

How do you evaluate a company?

There are risks with any investment. It’s a good idea to find out whether a company is making money or losing money, and why, before you investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition.

There are factors that can give you insights into how a company may respond to opportunities and risks. But even sophisticated investors can struggle when assessing a sectorSector A part of the economy where businesses provide the same or related products or services. May also refer to a group.+ read full definition they are unfamiliar with. If you have trouble explaining what the business produces, or how it makes money, you may find it hard to understand the risks that could affect its performance.

To help you evaluate whether to invest in a company, consider:

1. The company’s performance

How a company manages its money says a lot about how it will withstand stock marketStock market The collection of markets and exchanges where stocks, bonds and other securities are issued or traded.+ read full definition changes or unexpected events. Review the company’s performance and ask:

  • Has the business been up or down in recent years? Will it borrow to drive growth? Issue new shares?
  • Does the balance sheetBalance sheet A financial statement showing a company’s assets, debts and how much money shareholders have invested in the company as at a certain date.+ read full definition show that it has enough assets (or current assets) to cover any short-termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition debts (or current liabilitiesLiabilities What a company owes, including money, goods or services.+ read full definition)? If a company is short on cash, this may be a warning sign.
  • How does the company plan to repay its debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition?

2. DividendDividend Part of a company’s profits that it pays to shareholders in proportion to the total number of shares held. The Board of Directors sets the amount. For common shares, the amount varies. It may skip dividends if business is poor or the directors invest money in things like new equipment or buildings.+ read full definition history

How the company manages dividends relates to its financial performance. Good dividends, with regular increases, tend to mean a healthy income stream for investors. Also, if the overall market drops, dividends help to support the stock’s price.

3. Financial track record and operating costs

There’s more risk if it’s a new company with no track record. Look at the financial statementsFinancial statements Reports that sum up a company’s financial data and tell you how it is doing. The four basic statements are: the statement of financial position (balance sheet, statement of profit or loss (income statement), cash flow statement, and statement of changes in equity.+ read full definition and prospectusProspectus A legal document that sets out the full, true and plain facts you need to know about a security. Contains information about the company or mutual fund selling the security, its management, products or services, plans and business risks.+ read full definition to find out if it’s making or losing money and whether it has been growing. The shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition price of a company with a good track record of growth, over many years, may be more likely to steadily increase in the future.

Does the company have the potential to grow? What evidence is there to show this?

What is in the company’s operating statements? Have the costs of running the business changed? If costs are going up while the company’s sales are not, it may be a warning sign.

4. Leadership

Do the directors and other company officers have a solid track record of success? What is their management style? Has company management changed often, or abruptly, in recent years? Look for stability in management, and for leaders with strong backgrounds in the industry and a good record of success in other companies.

How is management compensated? Do their salaries seem reasonable compared to how the company is doing? How much of the company do the directors and officers own? Have any directors ever been in trouble with regulators?

Before you invest in a company, find out about:

  • the structure of its board of directors and their qualifications.
  • its governance practices.

5. Other risk factors

There are other factors that could potentially affect the company’s performance and its future growth. You can usually find out about future risks by reading the management’s discussion and analysis (MD&A) section of the annual reportAnnual report A financial report that a company prepares for its shareholders each year. Includes a balance sheet, financial statement, auditor’s report, and information about the company’s operations and financial situation.+ read full definition. For example:

  • Is the company trying something new and untested? If yes, who are its competitors and how successful are they? If other players are more established, this company may have a tough time breaking into the market.
  • Are there signs the company will need financing soon? If so, what are its plans for raising funds? If the company borrows money a lot, it may need more money again in the future.

What financial metrics can you use to evaluate companies?

Whether you are working with an advisor or a do-it-yourself investor, it’s good to be as informed as possible before you invest. Financial ratios can help you understand if a company is profitable or losing money. And whether the stock price is over- or undervalued. And how their financial performance compares to their competitors.

Three financial indicators to consider when looking at a company are:

  • Price-to-earningsEarnings For companies, it’s the money they make and share with their shareholders. For investors, it’s the money they make from their investments.+ read full definition ratio (P/E ratio) – The P/E ratio divides the company’s share price by its earnings per shareEarnings per share A company’s profit divided by the number of shares.+ read full definition. If a company has a high P/E ratio, the company’s stock may be overvalued or too expensive. Conversely, a low P/E ratio can indicate that a stock is undervalued. Generally, investors consider a P/E ratio under 10 to be a sign of value, but this benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a stock market index may be a benchmark you can use to compare how well your own stocks are doing.+ read full definition varies by industry. The P/E ratio is also helpful for comparing one company to another.
  • Price-to-book valueBook Value For investors, it’s what you paid for an investment. For companies, it’s the true value of everything that it owns. If the company had to close its doors and sell everything, the book value is the amount that shareholders would get (amount of net assets that the business owns).+ read full definition ratio (P/B ratio) – The P/B ratio divides the company’s share price by its book value. This ratio is used by investors looking to identify under-valued companies and avoid those that are over-valued.
  • Price-to-sales ratio (P/S ratio) – The P/S ratio divides the company’s share price by its sales price per share. This ratio is used to show how much investors are willing to pay for a share in the current market.

Learn more about how to buy and sell stocks

What are disclosure documents and why are they helpful?

Once you know what kind of business details you’re looking for, the next step is to know where to look for them. A good place to start is by reading the company’s disclosure documents.

Provincial securities commissionsCommissions What you pay to a broker or agent for their services. Often called a “sales commission”. For example, you pay a fee to someone who buys or sell stocks or real estate for you.+ read full definition require public companies to file documents such as:

  • annual information forms
  • annual and quarterly financial statements
  • management’s discussion and analysis (MD&A)
  • management information circulars
  • material changeMaterial change Any information about the company that would have a significant effect on a stock’s price once it becomes known to the public. Examples: Takeover, management changes, new products.+ read full definition reports
  • prospectuses

These disclosure documents contain information that can help you to assess a company’s management, products, services, finances, prospects and risks. Make sure the documents you review are as up to date as possible. A lot can happen within a company even in a few weeks or months.

Exceptions to the prospectus rule

Generally, securities offered to the public in Ontario must be offered with a prospectus — a document that provides detailed information about the security and the company offering it. However, there are some exemptions to this rule. Learn more about the exempt market and the different types of prospectus exemptions.

What if disclosure documents are late or incorrect?

If a public company files a disclosure document late or information is incorrect, the securities commission may require the company to refile or correct the document. In some cases, it may issue a cease trade order. A cease tradeTrade The process where one person or party buys an investment from another.+ read full definition order can suspend all trading in a company’s securities or prohibit individuals and companies from trading in certain or all securities.

If you hold stock in a company that has been ordered to stop trading, find out if it has any plans to apply to have the order removed. In some cases, the company may file for bankruptcy.

To find out more:

Where else can you find out information about a company?

In addition to disclosure documents, to help you evaluate a company, you can also look at:

  • Annual reports – These will offer insight into the company’s operations and financial status, and whether the company is making or losing money and why. These reports will also include statements from the CEO and other leadership on the company’s performance, as well as industry trends and events that may have affected stock performance.
  • News releases – Public statements issued by the company provide information about what it considers newsworthy about its operations. This can include news of new contracts, mergers and acquisitions, management changes and earnings releases.
  • Company website – Alongside news releases and annual reports, the website may also share information such as quarterly statements, executive speeches, research and reports, webcasts, and more.
  • Securities regulators – In Canada, you can find out if a company has been in trouble with a stock exchangeStock exchange A market in which securities are bought and sold.+ read full definition or commission through:
    • The Canadian Investment Regulatory Organization (CIRO) consolidates the operations of the Investment Industry Regulatory Organization of Canada (IIROC)Investment Industry Regulatory Organization of Canada (IIROC) National self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada.+ read full definition and the Mutual FundMutual fund An investment that pools money from many people and invests it in a mix of investments such as stocks and bonds. A professional manager chooses investments that match the fund’s goals for risk and return. You can redeem your fund units at any time.+ read full definition Dealers Association of Canada (MFDA). CIRO oversees all investment dealers, mutual fund dealers and trading activity on Canada’s debt and equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition marketplaces.
    • The Ontario Securities Commission reports on hearings for companies doing business in Ontario. Other provincial securities commissions will also report this information on their websites.
    • The Ontario Securities CommissionOntario Securities Commission An independent Crown corporation that is responsible for regulating the capital markets in Ontario. Its mandate is to provide protection to investors from unfair, improper or fraudulent practices, to foster fair and efficient capital markets and confidence in capital markets, and to contribute to the stability of the financial system and the reduction of systemic…+ read full definition publishes investor warnings and alerts.
    • The Canadian Securities Administrators (CSA) publishes bulletins about Investor Alerts.
  • Other sources – There are other sources you can consult, including:
    • Your investment firm – If you’re investing with a full-service firm, your advisor can help you choose individual stocks and give you general investing information. If you’re using a discount brokerageDiscount brokerage A brokerage firm that charges lower fees to buy and sell investments, as opposed to a full-service brokerage. Does not provide investment advice.+ read full definition, check the website for research and investing tools.
    • SEDARSEDAR See System for Electronic Document Analysis and Retrieval.+ read full definition – By law, public companies in Canada generally must file disclosure documents on the System for Electronic Document Analysis and Retrieval (SEDAR).
    • Toronto Stock Exchange (TSX)Toronto Stock Exchange (TSX) Canada’s largest stock exchange, North America’s third largest stock exchange, and the sixth largest in the world.+ read full definition – You’ll find up-to-the-minute information about stocks and companies listed on the TSX, annual reports and historical market data.
    • Securities Exchange Commission (SEC) – The SEC is the U.S. securities regulatorSecurities regulator A government agency that enforces the securities act in jurisdiction it has authority over. This act is made up of laws that establish rules for issuing and trading securities. The Ontario Securities Commission is the securities regulator for Ontario.+ read full definition. You’ll find information on U.S. stocks.

If information a company tells you turns out to be wrong or misleading, consult the prospectus (if the company is required to file one). It will tell you your legal rights to stop a purchase or to sue for damages. These rights tend to be limited, so it’s important to do your research before buying a stock.

There’s a wealth of information online about stocks and plenty of advice about what stocks to buy. But how do you know who to trustTrust An account set up to hold assets for a beneficiary. A trustee manages the assets until the beneficiary reaches legal age.+ read full definition? Find out as much as you can about the background and expertise of the person or firm who is offering the advice. Are they profiting from giving this advice? The more you know about the source, the better you can assess the risk.

Summary

It’s a good idea to find out whether a company is making money before you invest. You can evaluate a company in many ways including by looking at its:

  • Performance, dividend history and leadership successes
  • Financial ratios to understand if the company is profitable or losing money. And whether the stock price is over- or undervalued.
  • Disclosure documents – that includes things like, annual and quarterly financial statements, management’s discussion, and analysis (MD&A), prospectuses, and more.
  • Annual reports, news releases, and statements from securities regulators.

You may also like…

Last updated