How Does Investing in a Company Work: 8 Tips to Understand

If not invested, money loses value pretty fast. An un-invested $1,000 capital will remain unchanged at $1,000 by the end of the year. Further, if you factor inflation and other market dynamics, that $1,000 would actually be worth much less. If the same amount is invested, chances are good that it would be worth more or, at the very least, retain its value.

Investing means you’re surrendering part of your capital in exchange for a slice of the company. That’s the simplistic way of looking at investments.

Below are eight tips to know on how does investing in a company work:

1. You Invest for a Slice of the Company

Many of us have this question: “How does investing in a company work?” The simplest answer is viewing your investment as if you’ve invested for a slice of the company. Business people do not invest in companies for the sake of investing; they are looking for a return on their investment, also known as ROI.

They want to make a profit. Their goal is to buy a company’s shares at a low price and hope to sell at a much higher price. This is important to them since money loses value if it’s lying dormant.

2. Investing as Debt (Loan)

A good analogy for investing in a company is by treating it as a debt at an agreed interest rate. Here, you are not looking for a share of the company. You just don’t want your money lying around losing value. So, you invest your funds as a debt to a company, so you can make money on interest.

3. Investing as Debt with the Option of Equity

In some cases, you may want to loan your funds to a company at an agreed interest rate with the option of converting your investment into equity at a predetermined price. This type of investment is pretty safe since you’re not bound to buy shares in the company should it perform under par. However, if the company does well and you would rather convert your debt into equity instead of cashing out, you have that option.

4. Your ROI Hinges on the Health of the Company

Assuming you purchased shares from a company, your goal is to make as much money as possible from your investment. However, how much you make (or lose) depends on how well or badly the company is doing. It’s important to monitor the company you’ve invested in so you can know when to divest. The goal should be to sell when the company is doing good to avoid losing money.

5. Look for Trends in the Company’s Earnings

Before putting your money into a company, scrutinize its net gain for a period. What you should be looking for are trends that indicate progressive growth over time. The increase in earnings may not be spectacular, but if they are steady and consistent, this is a positive sign. These trends may indicate the potential future growth of your business investment opportunities.

6. The Stability of the Company Is Key

Besides consistent and steady earnings, you want to know how stable the company has been over the years. Granted, every successful business has at one point or another experienced economic turbulence. That’s a given, and it shouldn’t worry you too much.

What should send warning signals, however, are frequent fluctuations that make it difficult to predict how the company will perform in the future.

7. A Company’s Debt-to-Equity Ratio Must Be Sound

That a company’s balance sheet has a debt column is not a big deal. Even the largest, most profitable companies have liabilities. What is a big deal, however, is a situation where a company’s debts are so large that they overwhelm its equity. In other words, the debt-to-equity-ratio should reflect more assets and as few liabilities as possible.

A debt-to-equity-ratio of 0.30 or lower is considered a safe bet. However, if your risk tolerance is high, or if the industry standard is set at a higher ratio, go ahead and invest.

8. Before Investing, Scrutinize How a Company Is Run

Establishing how well a company is run is critical before making an investment decision. The people in charge must earn your confidence by demonstrating their competence in running the company. Their track record and their integrity should be important to you.

You also need to understand the company’s culture and history of innovation. These metrics are critical since companies are as good as the systems and the people that run them.

There are many things you should establish when investing in a company. Doing due diligence to establish the soundness of the company you want to invest in is critical. However, besides a healthy balance sheet, the integrity and a proven track record of the stellar performance of its management is the most reliable predictor of future success.

Once you are confident all is looking good, go ahead and invest your capital. While you’re at it, remember that market dynamics fluctuate, sometimes too quickly. Therefore, always look at investing for the long-term. That said, knowing when to divest from a company is equally important. At the end of the day, every investor is looking for a handsome return on their investment.

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