How to evaluate companies when buying stock

10 min read

Before you buy stock in a company, it’s a good idea to evaluate whether it seems like the right investment 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 you’ll find

Where can you find out information about a company?

There’s a wealth of information online about stocks and plenty of advice about what stocks to buy. But how can you learn more about a company before you invest in it?

Public companies and investment funds are required to disclose key information to investors. To help you evaluate a company, you can look at:

  • Company websites – Most publicly traded companies post annual reports and other financial information on their websites, as well as news releases, quarterly statements, executive speeches, research and reports, webcasts, and more. Annual reports offer insight into the company’s operations, financial status, and why the company is making or losing money. 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.
  • SEDAR+ – The System for Electronic Document Analysis and Retrieval (SEDAR) is for the official filing of documents (called disclosure documents) by public companies and investment funds across Canada. You can access this information free of charge.  
  • SEDI – System for Electronic Disclosure by Insiders (SEDI) – A mandatory filing system that collects the reports of all securities transactions made by people who are considered insiders of a company (for example, officers and directors of a company). You can access this information free of charge.
  • Securities regulators – In Canada, you can find out if a company has been in trouble with a stock exchange or commission through:
  • Canadian Investment Regulatory Organization (CIRO) – A self-regulatory organization that oversees all investment dealers, mutual fund dealers and trading activity on Canada’s debt and equity marketplaces.
  • Ontario Securities Commission (OSC) – Reports on hearings for companies doing business in Ontario. Other provincial securities commissions will also report this information on their websites. The OSC also publishes investor warnings and alerts.
  • Canadian Securities Administrators (CSA) – Publishes investor warning and alerts.  
  • Third-party websites – You can get information on past stock prices and trends from many websites. Including Globe Investor, Morningstar, Stockwatch and Yahoo Finance. You may have to pay a fee in some cases.
  • 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 brokerage, check the website for research and investing tools.
  • Toronto Stock Exchange (TSX) – 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 regulator. You’ll find information on U.S. stocks.

How can you evaluate a company before investing?

All investments come with risk. Even sophisticated investors can struggle when assessing a sector they are unfamiliar with. If you have trouble explaining what the business produces, or how it makes money, you may find it hard to evaluate how risky it is as an investment.

When you buy stocks — or shares — you are investing directly in a company.  It’s a good idea to find out whether a company is making money or losing money, and why, before you invest.

When consulting sources like the ones listed above, look for information about the following:

1. The company’s performance over time

How a company manages its money says a lot about how it will withstand stock market changes or unexpected events. Review the company’s performance by asking questions such as:

  • Has the business been up or down in recent years? Will it borrow to drive growth? Issue new shares?
  • Does the balance sheet show that it has enough assets (or current assets) to cover any short-term debts (or current liabilities)? If a company is short on cash, this may be a warning sign.
  • How does the company plan to repay its debt?

2. Dividend 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 statements and prospectus to find out if it’s making or losing money and whether it has been growing. The share price of a company with a good track record of growth, over many years, may be more likely to steadily increase in the future. Consider questions such as:

  • 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

Before you invest in a company, it’s a good idea to find out about the structure of its board of directors and their qualifications and its governance practices. In reviewing information about the company leadership, consider such questions as how often the company management has changed, whether management or directors have been in trouble with regulators, and whether their compensation seems reasonable compared to performance.

Look for stability in management, and for leaders with strong backgrounds in the industry and a good record of success in other companies.

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 report. 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 struggle in 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.

All investments come with risk. Knowing your risk profile is important for making investment decisions. Always do your own research or speak with a qualified professional for advice.

What financial metrics can you use to evaluate companies?

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-earnings ratio (P/E ratio) – The P/E ratio divides the company’s share price by its earnings per share. 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 benchmark varies by industry. The P/E ratio is also helpful for comparing one company to another.
  • 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.
  • Price-to-book value 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.

What is book value?

Book value is an accounting term referring to a company’s net worth according to its historical financial statements. It represents what assets are left on its financial statements after debts are paid. It also may be referred to as shareholders’ equity, the value left for shareholder claims on a company’s assets. In most cases, a company’s book value may not represent its market value and therefore is not a substitute  for a company’s worth.

Generally, the worth of a company is based on a determination, which estimates net worth based on a combination of factors including current market conditions, risks and other company-specific details that a buyer would reasonably consider in an open and competitive market.

To figure out a company’s book value, first find out how much it owes (liabilities) and how much it owns (assets). Then, you can calculate book value, or shareholders’ equity, by subtracting liabilities from assets.

For example, if a company has $100,000 of assets and $60,000 in liabilities to suppliers and bank loans, the shareholders’ equity would equal $40,000 ($100,000 minus $60,000). The $40,000 in shareholders’ equity belongs to company owners, its shareholders. It’s the company’s book value, or net worth according to its financial statements. It’s not necessarily its market value.

You can also find out book value by looking at a company’s financial statements. Book value can be calculated based on the information located  on the statement of financial position (commonly referred to as the balance sheet). It summarizes a company’s financial position at a moment in time and can be found under the heading Shareholders’ Equity, often located under liabilities.

A company’s balance sheet must always balance. That means, what the company owns (its assets) must equal what it owes (its liabilities) plus what’s left over for owners (shareholders’ equity). It’s a core accounting concept, represented by the formula: assets = liabilities + shareholders’ equity

In this case, the company owns $100,000 of assets. It owes $60,000 and the remaining $40,000 belongs to the owners. As you can see, the financial books stay balanced.  $100,000 = $60,000+$40,000

What is book value per share and how is it calculated?

Investors often want to know what a company is worth, most commonly on a per share basis. Book value per share (BVPS) provides a quick way of seeing how much of a company’s net worth (assets) an investor “owns” for every share they hold.

Investors often compare book value per share to a stock’s market price:

  • Below book value – may suggest low confidence in performance or a cautious market.
  • Above book value – may suggest optimism about the future or company performance.

In simple terms, book value per share is calculated by taking the total shareholders’ equity and dividing it by the number of outstanding (total) shares issued by a company (located by reviewing a company’s financial documents). The basic formula would be: book value per share = shareholders’ equity ÷ outstanding shares.

For example, if the company in the example above issued a total of 10,000 shares, each share represents $4 of book value ($40,000 ÷ 10,000).  

Some companies have different types (or classes) of shares, like common and preferred, which change how book value may be divided among shareholders. This example assumes one type of share, common shares.

Market prices are influenced by a range of factors. Book value can serve as a useful reference; however, it’s one measure out of many used to understand a company’s value. It is not a measure that investors generally should use in isolation. 

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 commissions 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 change 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 which you can search on SEDAR+. A cease trade 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:

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 can be found on the company’s website or filings on regulatory websites like SEDAR+.
  • Annual reports, news releases, and statements from securities regulators.
Last updated