How Not to Overpay for Stocks when Investing Online

By Matt Krantz from Investing Online For Dummies, 8th Edition

Even if you find a great company with a top-notch management team and popular products, it doesn’t mean you should buy the stock. The sad truth is you’re probably not the first or only person to know about the company’s bright future. And if other investors bought the stock already, they likely have pushed the stock price higher.

When a stock price has already risen in anticipation of good news, the good news has been priced in. That means even if the good news you’re expecting pans out, the stock price might not budge — or may even fall — because it already nosed up previously in anticipation of the good news.

The difficulty of evaluating a stock’s valuation is one reason why investing in individual stocks is more complex than buying and holding index mutual funds and exchange-traded funds (ETFs). Here are some things you should ask yourself before you decide to buy a stock:

Does the stock fit into your asset allocation? If your portfolio is already stuffed with small companies, you might not want to add another small company. Instead, you should invest in different types of companies that better fit your asset allocation plan.

Morningstar provides an easy way to find out where a stock would fit in your asset allocation plan. Just type the stock symbol in the Quote box and press Enter. Scroll down quite a way and you can see the Company Profile section. In the Company Profile section, you’ll find the Morningstar Style Box in the middle of the page — right there under the Stock Style heading. (The Morningstar Style Box is very small, so it’s easy to miss, but it’s a big help.)

The box uses a nine-by-nine grid to show you whether the stock is large, mid-sized, or small. (The grid also tells you whether the stock is value priced or is a growth stock.)
Does the stock have solid fundamentals? When you pick apart a company’s financial statements, you’re doing what’s known as fundamental analysis. Essentially, you determine how fast the company’s revenue and earnings are growing and examine the management.
Does the stock stack up favorably against the competition? Companies that have a defendable edge against rivals — typically thanks to a strong brand name — can remain more profitable.

Credit: © 2012 Morningstar, Inc. All Rights Reserved. Reprinted by permission of Morningstar.
Is the price for the stock reasonable? You should study how much other investors are paying for the stock before you jump in. Overpaying for a good company is just as bad as overpaying for a bad one. You might lose money in both cases.

A stock’s price alone doesn’t tell you how expensive or cheap a stock is. Just because one company’s stock price is $100 and another company’s stock is trading for $1 doesn’t mean the $1-a-share company is cheaper. The stock’s share price must be compared with something else, such as earnings or revenue, to determine its value.