What To Look For When Screening Potential Equity Investments
Like every other option within your reach, equity investments are inherently risky. With limited knowledge and experience, you may not be able to make the best decision that will command that impressive ROI you want.
Interestingly, the best decisions often start from the point of evaluating the investment. The big question is this – what should you look for when screening potential equity investments?
Perhaps, the consequences of improper screening are always fatal. But you don’t have to experience those consequences. Irrespective of your background or current stage, this post aims to highlight some of the crucial factors to consider when screening equity investment options.
What Is An Equity Investment?
Equity investment is a type of financial transaction that gives an investor defined ownership units of a company’s share, assets, and liabilities. Yes, there are some liabilities involved in most cases. Examples are tax and other financial liabilities directly related to the ownership of measurable equity in a company. In practical terms, the nature and type of equity define the liabilities involved.
In other words, equity investments are rarely the same. Below are the major types of equity you’ll find in every economy or capital market.
- Common shares
- Preferred shares
- Equity mutual funds
- Retained earnings
- Private equity
The Factors To Watch When Screening Potential Equity Investment
The trends happening within an economy or industry can affect the viability of a company’s equity. For example, during the COVID-19 pandemic, the trending lockdown orders around the world accelerated the demand for online learning and remote work tools. Interestingly, that trend directly impacted the growth of Zoom communications and other similar video conferencing tools.
Fortunately, the people who invested early enough become beneficiaries of the booming video communication trend.
On the other hand, when a specific trend affects specific industries, most companies operating within such sectors will be affected negatively. The point is that you should study the specific industry and economic trends. Analyze the companies that interest you to understand if the demand for their products is growing, static, or declining.
Only a stable company can afford to take the risk of exploring growth opportunities within specific niche markets or industries. With cash flow stability, the potential equity investment in the company that interests you might not be viable enough. When you invest in a company’s equity, you are betting on the company’s future performance. To some extent, the consideration of that future performance influences the price you pay for the equity investment.
Unfortunately, a company might not reach its performance targets if cash flow stability is not maintained. Besides, it is not just about bringing in revenue. Is the company operating at a multi-year loss or recording some impressive profits? Your task is to study their quarterly financial statements to understand some of these fundamentals.
What does the company’s dividend payment history look like? Here is another salient point to consider when evaluating potential equity investments. Even though past performance is not a perfect guarantee or indicator of future performance, a verifiable history of successful dividend payout is positive.
Through an in-depth analysis of a company’s dividend payment history, you’ll gain the insight to decide whether their equity investment is viable or not. Perhaps, sustained payment of dividends to investors will directly impact the value of your investment. However, you need to buy and hold for a long time to reap the benefits of value appreciation.
By conducting deep research, you’ll identify some of the best dividend-paying companies with viable equity investment options. Besides, you may consult your financial advisor to give you the best guidance to spot the best deals.
Debt position is another interesting factor that influences the viability of potential equity investments. When a company is deeply in debt, one or all of these things often happen.
- A big chunk of profits goes to debt servicing.
- The company will have limited cash to pay a dividend
- The debt burden may lead to missed growth opportunities
On the other hand, a deeply in debt company is vulnerable to external interferences. Such interferences may pose operational and survival risks because of the debt burden. These are some reasons you shouldn’t ignore debt position when screening potential equity investment.
Litigation is one type of risk that threatens a company’s survival, efficiency, market share, and profitability. Even though it doesn’t happen very often, you shouldn’t ignore the potential effects of ongoing litigations on a company’s equity viability. When a company is struggling with multiple litigations, it may affect things like supply partnerships, declining demand for its products, and the ability to pay a dividend to investors. These are potential risks you have to analyze before investing your hard-earned money.
Sometimes, litigations can come from government agencies, competitors, non-profit organizations, trade unions, and ill-minded insiders. Depending on the size of potential equity investment you want to make, consulting a lawyer of a financial advisory firm will prove helpful.