5 Important Steps to Follow Before You Buy any Stock

For most men, two of the scariest words they'll ever hear are "I do." 

Without a doubt, marriage is one of the most difficult decisions a person can face. But for men in particular, the mere thought of uttering these words prompts painful visions of a future filled with deep commitments, like sharing the TV remote control, being forcibly dressed to go out, hosting combination Pampered Chef/Monday Night Football events and standing outside dressing rooms in shopping malls holding nothing more than your wife's Italian-made cheetah-skin purse. Scary, indeed.

  To tell you the truth though, I actually enjoy the uncomfortably weird things my wife puts me through (well most of them). It makes me step outside of my box and it most definitely builds character.

Over the years, I've found the key to a long and happy marriage is dependent upon how committed we are to each other. The more we put into it, the more we get out of it. It's a simple equation.

Likewise, when it comes to investing, the more you put into it, the more you'll get out of it. Investors, who diligently research their investments before making a decision, more often than not reap greater returns than those who do not.  

With this in mind here are five rules you should follow before "committing" to a single stock and five key qualities the "perfect" stock should possess. 

Step one: Look at a company's management team along with its products and services. If a company makes gizmos and gadgets nobody wants or need, then there isn't a market to support its growth. It stands to reason not many people will want to buy the stock either. 

But if you've found a company with products or services that are in high demand, then you could be sitting on a gold mine.

A few years back when Apple (Nasdaq: AAPL) introduced the iPod, some investors shrugged off the potential growth of this gadget. Boy, were they wrong! In 2004 and 2005, iPod sales went through the roof, as everybody on the planet wanted one. As a result, Apple's stock has climbed more than tenfold in the past five years. In sum, find ing a company with products or services that are in high demand is a must.

Just as important, the company should have strong leadership to deliver the products and services to the marketplace and maximize shareholder value. Good management doesn't always mean a stock will perform well, but a company with terrible managers almost always equals bad stock performance. 

Research whether management has made accretive acquisitions, increased dividend payments, approved stock splits and share repurchases, minimized stock dilutions, paid down debt, and made other decisions pleasing to shareholders. 

Step two: Consider the markets within which a company operates. The goal is to find a company with superior products or services that has few, if any, competitors and is operating within a unique market niche that is rapidly expanding. 

Step three: Revenue and earnings should be increasing. In the investing world, a firm's revenue and earnings are by far the main attraction. If a company falls short on the earnings side, then it is likely the stock will be punished. If a company exceeds expectations, then it is highly probable the stock will be headed higher.

Focus on companies with increasing revenue and earnings in the past five years, at least. And if you find a company that continues to beat expectations and yet Wall Street doesn't seem to notice, then you may have found a dream "buy."

Step four: Look for rising margins. How much money is a firm squeezing out of every dollar it makes? To answer this question, you have to look at a company's margins.

Rising margins are a good thing, but you have to dig a little deeper to understand whether they are sustainable. If a company's improving margins are due to short-term events such as product pricing increases or an unusual drop in raw material prices, then the current margins may be short- lived. In contrast, if the company has found a way to improve efficiencies by adding new technologies, paying down debt, or cutting unproductive operations, then the current higher margins may be sustainable or even continue to improve.

Step five: Make sure they have plenty of cash and low debt. Focus on a company's current and past cash flow. A company with diminishing cash flows can be worrisome. A company with increasing cash flow can be a beautiful thing.

Free cash flow (FCF) is also an important factor. FCF is simply the amount of cash flowing through a company during a quarter or year after all cash expenses have been paid. FCF is important because it represents the actual amount of cash left over, which can be used to increase shareholder value in ways such as repurchasing shares, paying dividends, or developing new products.

Another key feature I look for is a firm's current cash position. The more cash a company has on hand, the more flexibility it has to make acquisitions or buy back stock when a good opportunity presents itself. 

Finally, it's crucial to look at a company's debt burden. A few years ago, I kept watching on the sidelines as a few analysts were suggesting General Motors (NYSE: GM) might be presenting a good buy opportunity. I love U.S. companies and I love GM vehicles, but no way was I buying into GM's stock. GM's debt load was horrendous and, as we now know, the ensuing burden was too much to overcome.

Some industries can afford to operate with high levels of debt, so you should always compare a company's debt-to-equity to that of other companies operating within the same industry. For example, utility companies frequently take on large amounts of debt in order to finance building new power plants. This practice is quite acceptable because once the plant is built it will produce tons of cash for many decades to come.

These five steps could help prevent a look of pain for investors. Having a disciplined process for evaluating companies is critical for long-term success. Just like marriage, finding the right stock takes time, patience, and focus.