Making the decision to click the buy button and invest your hard-earned cash in a stock is an important step in an investment journey and often the most difficult part.

Knowing your money is at risk inevitably makes it tricky to commit and any reticence could mean you miss exciting opportunities.

To help you get over this hurdle we are going to look in detail at when you should consider buying a stock using real-world examples to illustrate the key points. We will take in how to get to grips with valuations, the key signals to look out for and the pitfalls to avoid.

Success is never guaranteed but by having a framework and a clear understanding of why and how you are making decisions you can help tilt the odds in your favour.

CHECKLIST: Times when you might want to buy a share

When the valuation looks too cheap against a company’s growth potential
When you think good news is coming
When there is a string of good news
When sentiment starts to improve towards a stock or sector
When there is positive share price momentum
When there are catalysts for a share rerating
When new management have a plan to fix a business
When a company’s balance sheet is strengthening

WHEN YOU BUY A SHARE, SOMEONE ELSE IS SELLING

If you buy a share, remember someone else is selling it. Your conviction that a stock is an outstanding investment is matched by someone who is equally convinced of the opposite view (unless they are just selling because they need the cash).

You are also saying the market, made up of thousands of other investors including institutions with large teams of analysts and professional portfolio managers, has priced a stock wrongly. No market is 100% efficient, so there will always be shares for whom this is the case, but it is a high bar to clear.

You also need a catalyst if your investment is to pay off. A stock can stay at a perceived ‘wrong price’ indefinitely without something to change the market’s perception.

Positive share price catalysts can include better than expected earnings, a contract win or improved sentiment towards or a company or its sector thanks to political or economic developments.

WHY YOU NEED TO KNOW WHAT THE MARKET THINKS

Knowing what the market thinks about a company before you buy is important. Just looking at a share price chart will give you a good initial guide. If the line is heading down left to right you can assume the market has a negative attitude towards a company.

When a company reports its earnings, often a share price won’t move even if the financial results are good. That’s because the market was already expecting those numbers – investors want to be blown away by the figures, not simply satisfied, in order for them to place an order to buy more shares and ultimately push up the price.

Valuation will also provide a clue on the wider sentiment towards a business. Often the best time to invest in a company is when everyone hates it but you need to have confidence something will happen to change the prevailing view.

WHAT ARE THE BIG QUESTIONS YOU SHOULD BE ASKING?

Before you make a share purchase, ask yourself these questions. They are both a good test of your confidence in an investment and a way of ensuring you have done the necessary homework.

How does the company make money? If you cannot answer this question, you should never invest.
Is the company profitable? If not, why not?
What is the track record of the company and its current management?
Who are its main competitors?
Does it have qualities like a strong brand or significant scale which can help it retain market share?
How strong is the balance sheet?
What is the valuation?
What are the potential catalysts to move the share price higher?

THE QUALITIES OF A GOOD COMPANY

While businesses in different sectors will have different attributes and strengths there are several qualities which are the mark of a good company.

PRICING POWER

This is the ability of a company to increase the prices for its goods and services without unduly impacting demand – something which is often reliant on the strength of its brand or brands.

What to look for: If a company is exposed to raw material costs, scan for evidence or commentary in its financial results that it has been able to pass these on to customers without causing sales volumes to decline.

MARGINS

High operating margins mean the company is keeping a healthy proportion of its revenue as profit.

What to look for: The margin is easy to work out – it is the company’s profits divided by its revenues, expressed as a percentage. Most large firms will report their margin performance explicitly although the measure of profit by which they measure margin performance can differ.

CASH FLOW

Strong cash flow is the lifeblood of any business as it allows a company to invest for future growth, while funding its operations and potentially paying out dividends to shareholders.

What to look for: In a results statement look for the ‘consolidated cash flow statement’ which offers a detailed breakdown of cash flows.

BALANCE SHEET

It is important to invest in companies with a sound balance sheet as shareholders are last in the queue to get anything back if a company goes bust. A weak balance sheet is one with significant debt relative to the size of the company while a strong balance sheet means a firm has plenty of cash in the bank or little or no debt.

Admittedly, most companies have at least some debt and a gearing ratio (the percentage of capital employed by the business that is financed by loans, in relation to that part of capital funded by equity) below 40% is acceptable.

If a company’s gearing is above 60% investors should be looking for evidence management are seeking to reduce borrowings.

What to look for: Net cash or net debt is the cash balance minus any borrowings and can be found in the section of a group’s results headlined ‘consolidated balance sheet’.

A UK-listed company which ticks all these boxes is Spirax-Sacro Engineering (SPX). The engineer makes products which help regulate flows of fluids and steam. By excelling in this niche, it can charge customers high prices and this feeds into sector-leading margins.

The company also generates plenty of cash flow which it can use to make bolt-on acquisitions, pay down debt and underpin a dividend which by 2023 had grown at a compound annual growth rate of 11% over the last 55 years.

The role of valuation

A great company might not be a great investment if you pay too much. In this section we delve into the role valuation plays in the success or failure of an investment.

While our earlier example of Spirax is undoubtedly a high-quality business, this attribute has been recognised by the market and as we write it trades on 27 times forecast earnings. This is a demanding rating for a business which, for all its strengths, is still exposed to fluctuations in the economy.

Many financial websites and software providers allow you to filter shares according to different valuation metrics including Stockopedia, Thomson Reuters Datastream, SharePad and Investing.com – some of which are free and others require a subscription.

A price to earnings or PE ratio is the simplest way to value a stock and is calculated by dividing the current share price by the forecast earnings per share. The FTSE All-Share trades on a PE of around 14 so anything below this level could be considered cheap while anything above this level could be considered relatively expensive. Anything above 20 is a genuinely premium valuation.

A PE does not tell you if earnings are growing. To encompass this factor within a company’s valuation, investors use the PEG or price to earnings growth ratio. A PEG is calculated by dividing the PE ratio by the forecast earnings growth.

A stock on a PEG of less than one is seen as offering attractive value. A PEG of less than 0.5 implies market scepticism about a company’s earnings forecasts. 

To return to Spirax, its forecast earnings growth of 10.6% and PE of 27 translates as a PEG of a little more than 2.5-times.

Neither metric is of much use if you are comparing companies with significantly different levels of borrowings. Alternative measures include EV/EBITDA (enterprise value to earnings before interest, tax, depreciation and amortisation).

A company’s enterprise value encompasses its borrowings alongside its market value. The EV can also be used to calculate the free cash flow yield.

Cash flow and free cash flow, which is what’s left over after a company’s bills have been paid, is always a good thing to monitor as, unlike earnings, it cannot be massaged through clever accounting.

Often private equity firms will compare the free cash flow yield of a potential bid target with the rate at which they can borrow to see if the deal stacks up. Other metrics to determine value include price to book or net asset value – often used when looking at banks or property stocks.

As we touched on earlier in the article, an attractive value opportunity means little without the catalyst to unlock it. Next, we turn to the different forms a share price catalyst can take.

Different types of share price catalyst

Results, trading updates and other announcements

Companies listed in the UK publish their financial results twice a year and many companies also publish regular trading updates in between. US-listed companies publish quarterly results. This allows for a regular health check on their performance.

When these results are better than what analysts had been forecasting it can act as a powerful catalyst for a stock, particularly one which is in the doldrums.

For example, Facebook, WhatsApp and Instagram owner Meta Platforms (META:NASDAQ) enjoyed its largest one-day gain in 10 years in early 2023 when its fourth quarter and 2022 results beat forecasts, with chief executive Mark Zuckerburg winning over investors with a pledge to pursue efficiencies.

Meta, which historically has traded above 25 times earnings, was on a multiple of more like 14 at the beginning of the year, reflecting market scepticism over its plans to spend big on the metaverse and weakness in the online advertising market. It has since announced plans to slash costs and focus more on artificial intelligence, while also saying its advertising income is proving to be resilient. These bits of news added up to powerful share price catalysts, triggering a big share price rally. Investors who were able to spot the positive signs in its commentary have been handsomely rewarded with big share price gains.

This underlines the importance of being able to read the market mood and spot when sentiment shifts, as that can be a good point at which to buy  a share.

There are plenty of other share price catalysts. For example, firms must disclose any price-sensitive information such as a takeover approach or when earnings are going to be significantly above or below expectations. Investors often buy on such news – either hoping the company will be taken over for a higher price than first put on the table, or that strong earnings means the company has hit a sweet spot and will continue to issue good news.

An unscheduled trading update which guides for higher than forecast earnings is often a powerful catalyst because, by definition, the news is a surprise to investors and can help change their point of view on a stock. It can lead to something called a ‘rerating’ which is when investors are prepared to pay a higher multiple of earnings to own a stock.

Mr Kipling cakes and Bisto gravy maker Premier Foods (PFD) is a good example of a rerating. In 2015, the shares traded on a prospective PE of a little more than five times, with £567 million of net debt more than outweighing a market valuation of less than £400 million.

For years, the company was seen as a zombie with all its cash absorbed by interest payments and nothing left over to invest in its brands. Having subsequently tackled its debt problem and addressed its pension liabilities, in part through big financial restructuring, the company reached a tipping point in 2020 whereby its cash generation started to enable it to pay down debt while putting money back into the business and paying dividends.

The share price reaction was dramatic and the stock now trades on a PE of 11 times and the business is valued by the market at more than £1 billion. And the good news keeps on coming. In March 2023, Premier Foods delivered an unexpected full-year profit upgrade driven by sustained positive trading momentum.

A contract win can also move the dial if it is of sufficient size. Energy services provider Petrofac (PFC) enjoyed 70%-plus gains in April 2023 as it booked a €13 billion contract alongside Hitachi Energy to supply multiple offshore wind platforms and onshore converter stations in the North Sea on behalf of the Dutch-German transmission system operator TenneT.

In May 2023 shares in UK micro-cap Mirriad Advertising (MIRI:AIM) surged more than 300% in a single day after it announced a tie-up with Microsoft, having built an interface to link with Microsoft Azure and its artificial intelligence capabilities.

It can be tricky to identify this type of catalyst ahead of time but you can look out for indications a business is starting to see signs of recovery or draw conclusions based on the performance of its competitors. It is also worth keeping a close eye on businesses which have been beset by issues which you believe are genuinely one-off or short term in nature. As these ease its performance can improve and this can help drive the shares higher.

Management change and restructuring

More of a slow-burning catalyst is a change of management and/or a restructuring of a business. The effects of which can be dramatic if the market is convinced genuine change is afoot. Serial underperformer Rolls-Royce (RR.), which makes engines for aircrafts, appointed former BP (BP.) executive Tufan Erginbilgic in July 2022 with a start date of 1 January 2023. Anyone who held the shares on the day he took the helm would be sitting on a gain of more than 60% as at the beginning of May 2023.

From the outset Erginbilgic was unsparing in his criticism of the business, describing it as a ‘burning platform’ in an address to staff reported in the media. This implied he was serious about changing its fortunes.

He was off to a good start as full-year results in February 2023 were significantly ahead of expectations. At the time Shore Capital analyst Jamie Murray said he expected a more centralised decision-making structure, adding: ‘Previously each division has allocated capital separately which has caused inefficiencies. Instead, we expect Rolls-Royce to announce a group-level allocation strategy, to limit waste and prioritise high return investments.’

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