How to Pick Stocks: 7 Things All Beginner Investors Should Know

How to Pick Stocks: 7 Things All Beginner Investors Should Know

Research is the first step before buying a stock. But what comes next? Here’s what you need to know.

How to do your homework before picking stocks to buy.

When you decide to try your hand at stock picking, it’s essential to do your homework. Your goal is to find a good value – especially if you plan to hold on to an asset for a while. But before you put full faith in a company, you should do thorough research by reviewing a stock’s fundamentals to monitor its viability and checking whether it deserves a spot in your portfolio. This isn’t a simple purchase – you are becoming a part owner of a company. So investors must be willing to do the proper analysis. Here are seven things you should know about a publicly traded company before investing your hard-earned cash.

Trends in earnings growth.

Over time, do the company’s profits generally increase? If so, it’s a pretty good indication that the company is doing something right. Even small, regular improvement over a long period can be a positive indicator. But earnings growth and value have to go hand in hand for the stock to be worth the investment. You want to look at the company’s financial reporting – available on the company’s investor relations website – quarter over quarter and on an annual basis, to examine whether revenue and earnings are growing or declining. Companies that show positive earnings growth tend to have financial and operational stability. You also want to understand the company’s plans to continue increasing earnings. A company that has a proven strategy to increase sales, attract new customers and develop new products could be one worth investing in.

Company strength relative to its peers.

Industry can be a great screener when investing. Start by looking at how an industry is represented in the market and establish what growth potential looks like in that space. However, when picking individual stocks within an industry, you need to look at where and how the company fits in. How does it fare against its competitors? What is its market share? Is there an advantage that allows it to stand out? These critical questions can help determine whether a company has an edge. To make a fair comparison, line up competitors of the same size or market capitalization and compare their profitability and stock performance over a period of time to understand their performance relative to one another.

Debt-to-equity ratio in line with industry norms.

All companies carry debt – even some of the most profitable companies, like Inc. (ticker: AMZN) and Apple Inc. (AAPL). Investors can use debt as an indicator of the company’s financial well-being. Watch out for companies with high debt levels relative to their equity, also known as debt-to-equity ratio, a metric used to measure a company’s total debt relative to market value. To find this number, divide the total liabilities listed on the company balance sheet on its earnings statement by the total amount of shareholder equity. For investors with lower risk tolerance, that number should be 0.3 or less, according to industry experts. There are exceptions, however. For example, look at the debt-to-equity ratio across industries. In the construction industry, there’s a reliance on debt funding, so a higher ratio might be acceptable. But if debt is too high, that could put pressure on profits. Make sure your pick is in line with industry norms or has a compelling story to explain why it isn’t.

Price-earnings ratio can give an indication of valuation.

The price-earnings, or P/E, ratio is a valuation metric that shows how well a stock’s price reflects the company’s earnings. When using fundamental analysis and value investing strategies, P/E ratio is one of the indicators of whether a stock is undervalued or overvalued by the market. To find the P/E ratio, divide the company’s share price by its annual earnings per share, either over the past year or estimated over the coming year. For example, if a company is trading at $40 per share and the earnings per share are $2.50 for the last year, the P/E ratio is 16, well below the average P/E ratio for an S&P 500 company in February 2022. The ratio is a key way to compare companies in the same industry or sector. A company with a lower P/E ratio is not valued as highly by the market as one with a higher ratio. Your job as an investor is to determine whether the stock deserves that lower valuation or whether the market is undervaluing it, which could make it a good stock pick.

How the company treats dividends.

A company that pays dividends is often one with a degree of stability – especially if the company has increased its payout consistently each year over decades. But watch out for companies that have very high yields, calculated by dividing a year’s worth of dividends by the stock price. A spike in dividend yield can mean a company is getting desperate and trying to attract or keep investors with that income stream. High dividends could also be an indication that a company isn’t investing enough in itself. A company can temporarily or permanently cut its dividend to secure more liquidity during challenging economic times. This doesn’t necessarily mean the company is in jeopardy, rather that the business may require more cash to pay immediate expenses. Companies can cut dividends if they expect lower earnings or short-term unexpected expenses, in which case they would retain the money that would have been distributed as dividends to address financial needs. But if a short-term problem becomes long term, you may have to reevaluate your position.

Effectiveness of executive leadership.

Evaluating a company’s leadership is more of a qualitative assessment, but it is essential to valuing a stock. How much do you trust the people at the top of a company? Effective leadership promotes a stable and long-lasting company culture, balanced with innovation and flexibility. Companies that invest profits in themselves develop their business growth and increase their footing in their industry. A well-managed company is often one that enjoys stock prices that trend higher over a long period, through different business environments. To evaluate the effectiveness of a company, it can be helpful to look into how long leadership has been with the company, what kind of expertise they bring and how it translates to bringing value to the company, and whether they are transparent and trustworthy with their shareholders. Investors can find transcripts of speeches given by executives or listen to quarterly earnings calls to get an idea of how a company’s leadership deals with shareholders.

Long-term strength and stability.

The stock market by its nature – day to day and year to year – is volatile. At some point, a company is going to lose value in the markets. But what really matters is long-term stability. In general, trend lines should smooth out and head higher. A company that weathers the downturns and comes back strong and that only seems to have real trouble when everyone else does is probably a good bet. Ultimately, a stable company exhibits some or all of these characteristics: grows revenue, maintains low to moderate debt levels, is competitively positioned in its industry and has effective leadership. These are just some of the many important components of stock picking. If one of these variables changes, investors should take note and determine whether it’s a buy or a bust.

Here are seven things an investor should consider when picking stocks:

  • Trends in earnings growth.
  • Company strength relative to its peers.
  • Debt-to-equity ratio in line with industry norms.
  • Price-earnings ratio can give an indication of valuation.
  • How the company treats dividends.
  • Effectiveness of executive leadership.
  • Long-term strength and stability.

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