How to pick the best stock is a question that every investor has. To get started, have a look at the steps listed below if you’re new to stock selection.
There are numerous approaches to stock selection. A chimpanzee might be taught to shoot darts at the financial section of a newspaper to choose a random portfolio. About half the time, the chimp would triumph over Wall Street.
There are simpler ways to choose stocks, though, if raising chimpanzees isn’t really your thing or you simply can’t locate a newspaper. You also have an advantage over Wall Street’s short-term concentration as an individual investor with a lengthy time horizon for your stock purchases.
1. Establish your investment objectives.
Not every investor wants to use their money to achieve the same goals. Young investors are probably more focused on long-term portfolio growth than short-term gains. Older investors, who are getting close to retirement age and intend to start living off of their holdings, are probably more concerned with capital preservation. And for some investors, receiving monthly payouts and dividends from their investments is what matters most.
Think for a moment about the objectives you want to achieve with your investment portfolio. No regulations exist. You can be in your 60s and want to build your portfolio, or you can be in your 30s and want some added stability from investments.
Which companies you look to purchase will depend on your objectives.
- Investors looking for income will look for equities with high dividend yields, as well as the cash flow and earnings necessary to sustain those payments.
- Younger companies with promising revenue growth but perhaps erratic results may attract investors seeking growth.
- The contrary is what those who are concerned in capital preservation will seek out: steadfast companies that have been operating for years and produce stable and predictable revenues.
2. Look for firms you are familiar with
A stock purchase makes you a part-owner of the company. You’re setting yourself up for failure if you don’t grasp the industry.
Would you have faith in yourself to assume complete control of a corporation whose operations you are unfamiliar with? How do you tell if the management you hire is doing a good job, even if they are great?
There are businesses everywhere. Consider the businesses that created the numerous goods and services you use every day.
Also take into account businesses that may indirectly affect you. Many companies never interact directly with customers. Who makes the devices that accept your payment when you check out at the grocery store? Who exactly manufactures the medications you purchase at the pharmacy? What tools are they employing? Where do mechanics acquire new parts from when they fix your car, and who makes the spare components? Who is truly in charge of constructing new towers and producing the equipment that goes on those towers when your phone connection drops because there isn’t a cell tower nearby?
The businesses you deal with on a daily basis might serve as a starting point for your research into numerous industries and the rivals in each one. If you don’t fully comprehend how a company generates revenue, you should either conduct some research or choose an alternative provider.
3. Identify the existence of a company’s competitive edge.
It’s time to start paring down your list of potential companies after taking into account a large number of them and their rivals. The most crucial quality to search for in a business is a long-term competitive edge, or what Warren Buffett refers to as a “moat.”
Buffett stated in a 1999 interview with Fortune that “the key to investing is not analysing how much an industry is going to effect society or how much it will expand, but rather determining the competitive advantage of any one business and, above all, the sustainability of that edge.” The goods and services that have extensive, long-lasting moats surrounding them are the ones that pay off for investors.
There are various different types of moats. You’ll be able to recognize them in the businesses you’re researching if you understand how elements like scale, switching costs, distinctive brands, intellectual property, and the network effect may offer a company a significant competitive advantage.
4. Establish a reasonable price for the stock.
It’s time to start looking at stock pricing once you’ve reduced the list of stocks you’re investigating to businesses with a significant competitive edge.
There are numerous methods for determining whether a stock’s current price represents a good bargain or not. To name a few:
- Price-to-earnings ratio (PE ratio): The PE ratio divides the share price of a company by its yearly earnings per share. When a business’s PE ratio drops below its historical average, investors can find good deals on the stock. The greatest companies using this metric are those with a track record of sustained growth and profit
A company may, however, be trading at a greater PE ratio than it did previously for a valid cause. Investors should be prepared to pay more per dollar of profits if earnings growth is anticipated to pick up over the next years. Keep in mind that expectations for the future affect stock prices. The past can only serve as a general direction.
- Price-to-sales ratio: Growth stocks with unprofitable or highly erratic earnings are better served by the PS ratio. Again, historical averages can serve as a good benchmark, but remember to take future expectations into account.
Not all sales are created equally, which is important. The majority of a company’s revenue growth may come from a new product or service that it introduces that has a very different profit margin than its primary operation. Investors must therefore modify their expectations about how the stock should price in relation to anticipated future sales.
- Discounted cash flow modelling: If you really want to get into the nitty-gritty, look at a company’s books and start estimating future increases in sales, profit margins, and other costs. Create a model for future earnings using those sales and operating expense forecasts. You can estimate the stock’s worth by reducing those cash flows by your necessary rate of return. You may calculate the stock price by dividing that by the total number of outstanding shares.
- Dividend yield is a crucial indicator to take into account if you’re interested in income. A stock may be trading at a favorable price if its dividend yield is higher than normal. Make sure not to get caught in a yield trap, though. Check the dividend’s safety based on the payout ratio of the company expressed as a proportion of earnings and free cash flow since dividends might occasionally be unsustainable. Additionally, make sure to ensure that the earnings and cash flow are stable and increasing by looking ahead. By assuming dividend increase over the following several years, you could even create your own dividend discount model.
5. Purchase a stock with a safety margin.
Purchasing firms trading below your estimate at a fair price is the final phase in stock selecting. Your safety margin is as follows. In other words, if your valuation is incorrect, buying considerably below your fair price will help you avoid suffering significant losses. That’s yet another element that makes Warren Buffett a successful investor.
You might not require a large margin of safety for a firm with consistent profitability and a positive future. If you take 10% off your desired price, you should be okay.
You might desire a larger margin of safety for growth stocks with less predictable results. Depending on how certain you are of your valuation, aim for 15% to 30%. This guarantees that you will be covered if things don’t turn out as planned, such as if the small firm encounters a new obstacle or a larger company decides to enter the market, because you bought your shares at a fair price.
It is not necessary to purchase a stock for the very lowest price. When a deal appears, believe in your own ability to conduct the necessary investigation and accept it.
You’ll uncover some profitable investments if you take the preceding actions and create a diversified portfolio of stock picks across a number of industries.