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.
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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 invest.
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 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 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 market 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 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.
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.
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 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 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-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-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.
- 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 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
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 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:
- Search cease trade orders through the Canadian Securities Administrators.
- Check with the Ministry of Consumer and Business Services to see if the company still exists.
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 exchange or commission through:
- The Canadian Investment Regulatory Organization (CIRO) consolidates the operations of the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA). CIRO oversees all investment dealers, mutual fund dealers and trading activity on Canada’s debt and equity 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 Commission publishes investor warnings and alerts.
- The Canadian Securities Administrators (CSA) publishes bulletins about Investor 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.
- 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 brokerage, check the website for research and investing tools.
- SEDAR – 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) – 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.
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 trust? 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.
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.