Key takeaways:

• Before investing in a stock, investors should understand what the company does, whether it is growing, and assess the state of its financial health

• It is also essential to decide whether the stock is trading at an attractive price, and what role it will play within your share portfolio

Even though investors are regularly advised to do their homework before investing in the stock market, a significant number of investors still source investment ideas from tips', forums, rumours, or based on products they interact with on a day-to-day basis.

It is not to say that these investments can't be successful, however, the rationale or due diligence behind these ideas is often quite limited or potentially even non-existent. 

Rather than trying to take a shortcut to success in the stock market, it pays to do your own due diligence. Where do you begin? One of the simplest ways to assess investment opportunities is to ask yourself these five questions before you buy a stock.

1. What Does the Company Do?

Although you'd think this would be pretty standard knowledge for any investor about to buy a stock, a company operations are not always as straightforward as they would seem. For starters, some companies offer multiple products or services, or they may even have separate divisions that cater to various practices across different industries. 

In fact, the question here really boils down to how a company makes its money. And by understanding what a company does, you'll gain an understanding as to where it derives (or hopes to derive) its revenue and earnings. 

The information should provide you with some perspective about industry competition, risks, challenges, and whether the company has a moat' or point of differentiation that increases its likelihood of success. Each of these follow-up questions build on the premise of understanding what the company does.

You can find this information by looking at the company presentations, annual reports, or website.

2. Is the Company Growing?

By and large, stock market theory would dictate that earnings growth leads to share price growth. It may be easier for a company to achieve this by cutting costs or rightsizing' the business, but higher revenue or improvements in gross margins are the real indicators of growth.

With this in mind, you may want to look at how fast a company is growing before buying shares in that business. If the company demonstrates a history of increasing sales over time, that should give you some insight that its product or service is in demand. Of course, a business has to make a profit, so it is important to look at margins to ensure that they are at least stable, and ideally, growing. 

Nonetheless, if the company is able to grow sales, the next place to look is earnings. Although start-ups or high-growth companies may sacrifice earnings in favour of revenue growth, investors need to consider whether there is a pathway for profitability.

And while past performance may be no indicator of future performance, the historic growth of a company earnings, let alone its share price, should give you a track record on management ability to consistently generate a return on assets, or a return on equity, as well as deliver sustainable dividends.

3. How Healthy Are the Company Finances?

While a company revenue or earnings growth might be encouraging, or the forecasts for future growth might be promising, cash is still king. That why a company balance sheet and statement of cash flow are arguably just as important, if not more important than the income statement.

The reason why cash takes on such importance is because it is the ultimate currency that a company relies upon to pay its bills in full and on time. It is also the means with which a company is able to invest in growth. Without adequate cash, a stock may face concerns about its capital position, which is often enough to weigh on its share price given concerns about capital raise dilution.

Furthermore, analysing the company cash flow will give you an indication as to the efficiency with which a company spends money. Between investing for manufacturing capacity, new product development, personnel wages, paying dividends, or any other expense - the cash flow statement will tell you where money is coming in, and more importantly, where it is heading out.

While debt in itself is not necessarily a bad thing, investors may want to take a look at how much a company has borrowed. Naturally, as interest rates rise, repayments also increase, so debt can become a trap for a company that is either yet to turn a profit, faces cash flow strain, or where revenue is vulnerable to a downturn. At the heart of this question is whether the company looks like it will be around in the years to come.

4. Is the Stock Trading at an Appealing Price?

Even if you understand the company operations inside out, and its financials stack up, valuation is a sticking point that all investors should pay attention to. 

As with any investment, the ultimate goal is to make a return on your investment. That means you want to invest at a level or price-point that affords you upside opportunity, and ideally, the most upside opportunity. 

If you expect the company to continue growing, and in turn its share price to appreciate, the exact timing of a buy' might be less concerning. However, there may be instances where the market already seeks to price in' the growth outlook of a company into its share price, potentially limiting the upside on your investment.

Investors often seek to value shares using financial ratios that focus on earnings, assets, or even the company sales in order to compare that company on a relative level against its peers, the industry at large, or even the broader market. This affords investors some scope to decide whether the stock is trading at a fair', expensive', or cheap' price. 

For more information on how to value shares, read our educational guide here.

5. How Does the Stock Fit in My Portfolio?

Perhaps the most important thing that any investor should consider when buying a new stock is whether that investment fits within their portfolio and their investing goals and objectives.

While some investors or traders may be inclined to invest on a whim from time to time, investments should be based on extensive due diligence. It is important to recognise whether the stock you are analysing aligns with your overall strategy or investment thesis, your risk appetite, as well as your investment horizon.

In addition, you should also take into consideration what exposure the investment will provide you with, particularly in the context of sector or industry exposure, and the overall weight that said stock represents within your portfolio. For example, if you already own several tech stocks, adding another share from the same sector will only increase your exposure to this segment and increase your risk.

It is important to consider these factors to ensure that you maintain a diversified and balanced portfolio, and so that you abide by your investment plan.