When selecting the right stock to invest in, you should pick ones that you are confident will perform well dependent on your strategy. For example, if you are looking to invest for the long run, you will look for companies that are stable, well-managed, and have the potential for slow growth in the long-term.
On the other hand, if you’re looking to trade, you will look for stocks that are undervalued and whose price will likely be corrected in the short-term.
Moreover, if you’re looking into more sophisticated strategies, you will search for stocks whose price will decrease in the future. Your trading strategy also depends on other factors such as the amount of money you have to invest, your risk aversion, the amount of time you’re willing to wait until you earn a profit, and your level of expertise.
For example, if you have recently retired and you’re looking to invest your life savings, the right stock would be one that is stable and pays dividends (i.e. blue chip corporations). This is because you can’t risk to lose your investment and you require a source of monthly income.
Contrarily, if you’re 22 years old, with your whole productive life ahead of you and like adventure, the right stock for you can be the one whose prices are likely to fluctuate and will bring you short term gains. Young investors usually like to experiment and learn, and they don’t mind risking their capital in the process.
Looking at financials
No matter what your personality or capital availability is, one of the most straightforward ways to analyze a company is by looking at its financial statements. These include the income statement, balance sheet and cash flow statement. What’s more important, you can obtain different financial ratios from the financial statements.
Read also: A simple guide to start investing in stocks
These ratios allow investors to objectively understand how a company functions and to compare it to others. Some important numbers and ratios to look at are:
The net income is equal to net earnings (profit) calculated as sales minus cost of goods sold, selling, general and administrative expenses, operating expenses, depreciation, interest, taxes, and other expenses. Net income is what a company has left after deducting all its expenses. This number is an important measure of how profitable the company is and what is left to distribute among shareholders.
A profitability ratio to measure the profitability of business activity. It represents how much of a company’s sales have turned into profits. In other words, it indicates how many cents of profit the business has generated for each dollar of sales.
For example, if a business has a 40% profit margin it means it has generated $0.40 cents of net income for each dollar sold. The higher the profit margin, the more profitable the company.
A ratio used to compare the amount of financing of a company that comes from loans (creditors) vs. equity (investors). The higher the debt to equity ratio, the more a company’s financing comes from creditors; this may not be a good sign, as it means that investors haven’t invested in the business as much as lenders and it may be due to a lack of trust in its performance.
A lower debt to equity ratio means a more stable business because equity does not have to be repaid to investors, whereas debt must be repaid to the lender through regular interest payments or the company will suffer penalties. Also, unlike equity, debt must be paid with interest which is more costly to the company.
Price-to-earnings ratio measures a company’s current share price relative to its per-share earnings. The P/E ratio formula is the market price per share divided by the earnings per share. It allows investors to understand the price they’re being charged per stock in order to receive one dollar in earnings.
There are two ways to obtain this ratio: one is using a company’s estimated future earnings (forward P/E) and the other, using its past earnings (trailing P/E). Even though the forward P/E can be a better indicator of what the earnings will look like, it also has some flaws such as the estimates may be incorrect. On the other hand, the trailing P/E uses past performance, so it is a more objective outlook, but it may not correctly predict what a company’s earnings will be.
The P/E ratio shows what the market is willing to pay today for a stock based on its past or future earnings. A high P/E could mean that a stock’s price is high relative to earnings and possibly overvalued. Contrarily, a low P/E might indicate that the current stock price is low relative to earnings and therefore undervalued.
The return on assets is a measure of how profitable a company is relative to its assets. It gives an idea of how effectively a company is using its assets to produce earnings. The higher a company’s ROA the better, because it means that the company needs less assets to produce more income; however, this largely depends on the industry.
Given that a company’s assets are equal to stockholder equity plus liabilities, the ROA provides a measure of how effectively a company is using its financing to create net income.
Return on Equity (ROE) is a measure of how effectively a company is using its stockholders’ equity to generate net income. The difference between ROA and ROE is that ROA takes into account all assets (equity + debt) while ROE only takes equity into account.
All these ratios tell us different things about a company and are very useful when comparing a company to similar ones in its industry and trying to understand its performance and profitability. By translating the numbers in a company’s financial statements to ratios, we are able to compare apples to apples among different companies.
Steps to select the right stock for your portfolio
Some general steps you can take towards selecting the right stock for you are:
- Define your investment strategy: Decide on different matters such as whether you want to hold your stock for a long time or if you want to engage in short term trading. Also decide whether you want your stocks to have low growth, pay dividends, grow over time, etc.
- Start small: Pick one stock and as you gain more experience you can gradually grow your portfolio.
- Invest what you can afford to lose
- Keep informed: Read about the markets in order to spot new opportunities or events that could affect the prices of stocks you own or want to buy. Being informed will help you to be proactive rather than reactive when it comes to price changes.
- Study the company: Look at a company’s financial ratios to get a good sense of how well its being managed, if it’s over or underpriced, where it gets its financing from, etc.
- Diversify: If you’re going to buy multiple stocks, it’s best not to put all your eggs in the same basket.
- Look at ETFs of the industry you’re interested in investing in to get a reference of what companies to invest in from looking at their top holdings.
Even though there is no formula to select the right stock for each investor, you can follow some of the strategies we’ve discussed in this article. If you don’t feel confident enough to do it on your own yet, FlexInvest can be a powerful tool to guide you through learning to invest by allowing you to select your level of risk, experience, and the portfolios you want to invest in.