How to Research a Company Before You Invest

A rising stock price can make a company look like an exciting investment. But a popular stock is not always a strong business. Even a successful company may be a poor investment if its shares are too expensive.

Before buying a stock, look beyond its price chart and investigate the company behind it. How does it make money? Is it profitable? How much debt does it have? What could help it grow, and what could cause it to struggle?

You do not need to be a financial expert to answer these questions. A simple research process can help you make a more informed decision.

Understand the business

Start with one question:

How does this company make money?

Find out what the company sells, who buys its products and which markets generate most of its revenue.

Useful questions include:

• What are its main products or services?
• Who are its customers?
• Which products or markets generate most of its revenue?
• Who are its main competitors?
• What could help the business grow?

You should be able to explain the business in a few sentences. If you cannot understand how the company earns money, it may be difficult to evaluate its opportunities and risks.

You can usually find this information in the company’s annual report or on the investor relations section of its website.

If the company is listed in the US, look for its 10-K. This is a detailed annual report filed with the US Securities and Exchange Commission. The section titled "Business" explains the company’s main activities, products and markets.

Examine its financial health

After understanding the business, look at its financial performance over several years. One successful quarter does not necessarily indicate a lasting trend.

There are three main financial statements to examine.

Income statement

The income statement shows how much money the company earned and spent over a particular period.

Important figures include:

• Revenue: Money generated from selling products or services
• Operating expenses: Costs associated with running the business
• Net income: Profit remaining after expenses, interest and taxes
• Earnings per share: The company’s profit divided across its outstanding shares

Check whether revenue and profit are growing. Revenue growth may indicate greater demand, but it is more encouraging when the company can also control its costs and generate profit.

Balance sheet

The balance sheet shows what the company owns and owes at a specific point in time.

It includes:

• Assets: Resources such as cash, property and inventory
• Liabilities: Financial obligations, including debt
• Shareholders’ equity: What remains after liabilities are subtracted from assets

Pay attention to debt. Borrowing can help a company expand, but excessive debt may become difficult to manage if profit falls or borrowing costs increase.

Compare the company’s debt with similar businesses. Normal debt levels can vary significantly between industries.

Cash flow statement

A company may report a profit without receiving the same amount in cash. The cash flow statement shows how cash actually entered and left the business.

Operating cash flow shows whether the company’s main activities are generating cash. Free cash flow is broadly the amount remaining after the company pays for assets needed to maintain or expand its operations.

A company can use this remaining cash to reduce debt, invest in growth, pay dividends or repurchase shares.

Connect the numbers

No single figure can tell you whether a company is a good investment.

For example, revenue may be rising while losses and debt are also increasing. Another company may report strong profit but struggle to generate cash.

Consider the figures together:

• Are revenue and profit growing?
• Is the company generating cash from its operations?
• Is debt growing faster than the business?
• Are profit margins improving or shrinking?
• Is the company regularly issuing new shares?

Issuing new shares can help a company raise money, but it may reduce the percentage of the business owned by existing shareholders.

Compare these figures with the company’s previous results and with similar companies in the same industry. Comparing a technology company directly with a bank or retailer may be misleading because their financial structures are different.

Identify the main risks

Every company faces risks. Your aim is not to find a company without risks, but to understand what could damage its business.

Possible risks include:

• Strong competition
• Dependence on one product or customer
• High debt
• Rising costs
• Regulatory changes
• Supply chain disruption
• Currency movements
• Economic slowdowns
• Technological changes

US companies describe their significant risks in the "Risk Factors" section of the 10-K.

Focus on the risks that could have the greatest effect on revenue, costs, cash flow or the company’s ability to operate. Also consider whether the company has a realistic way to manage them.

Review management and recent news

Financial statements show what happened, while management’s explanation can provide more context.

In the Management’s Discussion and Analysis section of the annual report, management discusses the company’s results, financial trends and major business developments.

Earnings releases, presentations and calls can provide more recent information. Compare management’s earlier plans with what the company later delivered.

Management naturally presents its own view of the business, so check its statements against the company’s financial results and official disclosures.

An annual report may be several months old. Before investing, also review:

• Quarterly reports
• Earnings releases
• Company announcements
• Regulatory disclosures
• Investor presentations
• Reliable financial news

US companies use Form 8-K to disclose certain important events, such as leadership changes, acquisitions, major agreements or new financial obligations.

Social media can alert you to a company, but it should not be your main source. Always verify claims using official filings and reliable sources.

Consider the price

Finding a strong company is only part of the research process. You must also consider how much investors are currently paying for it.

One common valuation measure is the price-to-earnings ratio:

P/E ratio = Share price ÷ Earnings per share

If a stock trades at $60 and earns $3 per share annually, its P/E ratio is 20. This means investors are paying $20 for every $1 of annual earnings.

A high P/E ratio may indicate that investors expect strong future growth. It could also mean that the stock is expensive compared with its current earnings.

A low P/E ratio does not automatically mean that a stock is cheap. The company may have weak growth prospects, financial difficulties or other significant risks.

Valuation ratios are most useful when comparing companies in the same industry. They should be considered alongside the company’s growth, financial health and risks.

Put your research together

Imagine you are comparing two companies in the same industry.

Company A has rapidly growing revenue, but it remains unprofitable, uses large amounts of cash and has rising debt.

Company B is growing more slowly, but it generates consistent profit and cash flow and has manageable debt.

Neither company is automatically the better investment. Company A may offer greater growth potential with greater risk. Company B may be more financially stable but have fewer opportunities for rapid expansion.

The final decision depends on the company’s financial position, future prospects, risks and current share price.

Research cannot remove investment risk. It can, however, help you make decisions using evidence instead of excitement, rumours or recent price movements.

Quiz

Question 1

Which financial statement shows how cash entered and left a company?

• A. The balance sheet
• B. The cash flow statement
• C. The share price chart

Correct answer: B

The cash flow statement shows the company’s cash inflows and outflows from its operating, investing and financing activities.

Question 2

A company’s revenue is growing, but its losses and debt are also increasing. What should an investor do?

• A. Invest because revenue growth guarantees success
• B. Examine its costs, cash flow and ability to manage debt
• C. Ignore the debt because the company is growing

Correct answer: B

Revenue growth alone does not provide a complete picture. Investors should also consider profitability, cash generation and financial obligations.

Question 3

Why should P/E ratios generally be compared between companies in the same industry?

• A. Companies in the same industry always have identical risks
• B. Different industries can have different growth rates and financial structures
• C. The P/E ratio predicts the future share price

Correct answer: B

Comparing similar companies provides more useful context because typical growth rates, risks and valuations can vary between industries.

Sources

• https://www.sec.gov/fast-answers/answersreada10khtm.html
• https://www.investor.gov/introduction-investing/getting-started/researching-investments/how-read-10-k
• https://www.sec.gov/resources-small-businesses/glossary
• https://www.sec.gov/oiea/investor-alerts-and-bulletins/how-read-8-k
• https://www.finra.org/investors/insights/stock-investing-due-diligence
• https://www.finra.org/investors/investing/investment-products/stocks/evaluating-stocks
• https://www.finra.org/investors/insights/financial-performance-metrics-every-investor-should-know
• https://www.finra.org/investors/insights/defining-value-investment

Frequently asked questions

Where can I find information about how a company makes money?

You can usually find this information in the company’s annual report or the investor relations section of its website. For US-listed companies, the "Business" section of the 10-K explains the company’s main activities, products and markets.

Which financial statements should I examine before investing?

Examine the income statement, balance sheet and cash flow statement. Together, they show the company’s earnings and expenses, what it owns and owes, and how cash entered and left the business.

Does revenue growth alone make a company a good investment?

No. Revenue may rise while losses and debt also increase. Consider revenue alongside profit, costs, cash flow and the company’s ability to manage debt, and compare several years of results with similar businesses.

Does a low P/E ratio mean a stock is cheap?

Not automatically. The company may have weak growth prospects, financial difficulties or other significant risks. Compare valuation ratios within the same industry and consider the company’s growth, financial health and risks.

Can company research eliminate investment risk?

No. Research can reduce uncertainty and help you make decisions using evidence instead of excitement, rumours or recent price movements, but it cannot eliminate investment risk.

Related terms

• Halal Stocks