Stock Research Guide

Buying a stock without researching it is like buying a car without driving it. It doesn't really make any difference how a stock behaves on any given day (unless you are day trading, I guess). It is more important to know as much as possible about the company behind the stock.

Once you have an idea of a company's financial health, management performance, product line, customer base and a myriad of other details, you can make an intelligent decision whether or not to take a position in that particular company.

You don't have to spend a lot of time doing your research. However it is important that you look into a few key indicators. It should take you about an hour per investment decision.

What you need to know

First of all, you need to know what a company actually does and what industry the company is in. Although this may seem insignificant relative to other indicators that you will look at, it is a very crucial fact. If you end up purchasing a stock in a declining industry, or one that has fallen out of favor for any number of reasons, the stock's value is likely to decline regardless of the individual company's performance.

The next key indicator is the company's market capitalization which is the number of outstanding shares multiplied by the stock's market value. This lets you see if the company has room to grow.  For example, a publicly held company with 10 million shares outstanding that trade at US $30 each would have a market capitalization of $300 million US.

Analysts classify companies according to their market cap (or Cap). This allows investors to get a handle on growth vs. risk. As a rule of thumb, large caps provide slower growth with lower risk, while small caps provide higher growth potential with a corresponding higher risk.

Different Types of Capitalization

Here are the standard categories that are assigned to companies.

Mega Cap - This group includes companies that have a market cap of $200 billion and greater. They are the largest publicly traded companies and include names such as Microsoft, Exxon, Wal-Mart and General Electric. Not many companies will fit in this category and those that do are typically the leaders of their industry.

Big/Large Cap - These companies have a market cap between $10 - $200 billion. Many well-known companies fall into this category and include names like Yahoo, IBM and Citigroup. Typically, large-cap stocks are considered to be relatively stable and secure. Both mega and large cap stocks are often referred to as "blue chips".

Mid Cap - Ranging from $2 billion to $10 billion, this group of companies is considered to be more volatile than the large and mega-cap companies. Growth stocks represent a significant portion of the mid caps. Some of the companies might not be industry leaders, but they are well on their way to becoming one.

Small Cap – Typically new or relatively young companies, small caps have a market cap between $300 million to $2 billion. Although their track records won't be as lengthy as that of the mid to mega caps, small caps do present the possibility of greater capital appreciation--but at the cost of greater risk.

Micro Cap – Mainly consisting of penny stocks, this category denotes market capitalizations between $50 million to $300 million. The upward potential of these companies is similar to the downside potential, so they do not offer the safest investment, and a great deal of research should be done before entering into such a position.

Nano Cap - Companies having market caps below $50 million are nano caps. These companies are the most risky, and the potential for gain is often relatively small. These stocks typically trade on the pink sheets or OTCBB.

Know the P/E ratio

The P/E ratio, or "price to earnings" shows how much current investors are willing to pay for each dollar that the company earns. For example, a price P/E ratio of 21 means that investors are willing to pay $21 dollars for every dollar earned. Usually, the P/E ratio stand between 18-24 for high growth firms. The P/E shows you whether or not the stock is under or overvalued. An example of a undervalued company would be a P/E ratio of 12 and a overvalued company would have a P/E ratio of 200. Although P/E is a good indicator, it is sometimes thrown off by surges in demand for a particular stock. P/E ratios are based upon current earnings and not on future earnings.

External Factors

Besides knowing about the particular stock, you should also keep abreast of certain external issues that could affect your share's price. Some of the important issues that you should keep an eye on are:

Inflation

A rise in inflation causes interest rates to rise which may affect the company's cash flow. Lower inflation rates cause interest rates to fall. Not a good thing if you are invested in bank stock, for example.

Interest rate fluctuations

A rise in interest rates generally causes the market to decline, while a decrease in interest rates generally causes the market to rise.

Unemployment figures

A rise in unemployment is often a sign of a slowdown in the economy. This could lead to lower interest rates as an effort to kick start the economy. Conversely, lower unemployment levels are a sign that the market is beginning to heat up. In this instance, there could be a rise in interest rates in an attempt to keep the market from from overheating.

Company News

You will definitely want to keep an eye on news items that relate to your company directly or to the sector that it is in. Adverse news stories can cause a stock's price to plummet and could wipe you out overnight.

In Summary

While it may seem like a lot, the process of researching a stock becomes routine after you've done it a few. The time invested in doing thorough research up front can go a long way towards protecting the value of your investments down the road.