Investing in stocks is a well-known approach to compound your wealth over the long term. Stocks have continuously turned people into millionaires over the past centuries and will most likely do so in the future.
One of the first questions coming up when you start investing might be what to actually look for when choosing the right stock.
This article is going to briefly provide you with fundamental and essential criteria that you should look for when searching for a great stock pick.
The truth is that the whole stock market can get very complex and intimidating, and if you want to actively invest and choose the right equities for your portfolio on your own, you’re required to spend a lot of time on constant research and learning to actually achieve decent success over the long term.
There are quite a few fundamental indicators and metrics that can give useful insights into the financial health of a stock. One way to assess those indicators is to simply ask the right question every time you try to analyze a stock.
How Good Are the Company’s Earnings?
First of all, you want to assess the value of the company that you are analyzing. Just the current share price of a stock for which it’s currently trading at, won’t say anything about the financial background of the business.
Think of it this way. The stock market is like a huge auction house, and every single second, buyers are willing to accumulate shares of stock for a specific price, while there are sellers on the other side who are offering their share of stock for their preferred price.
This also means that stock prices are completely determined by investors and their current view and expectations of the company behind that stock. As a result, stock prices constantly go up and down in the short term. That fluctuation is also called volatility
Oftentimes, stocks are not priced appropriately to their fundamentals and the actual company’s value. When this instance occurs, investors consider a stock as either undervalued or overvalued.
One of the most important fundamental factors of a stock is its earnings. Let’s assume that you have the choice to either buy a business for $1000, which is making $75 every year in earnings, or a business which is making $100 a year for the same price, which option would you choose? Of course, the choice would fall for the second business since the second business is earning more money than the first business while selling at the same price.
It is vital to realize that you are essentially becoming an owner of that business when you’re buying its stock. And probably one of the first questions you as a potential business owner would ask is how much your business is earning before you consider buying it right? It isn’t any different for investing in stocks.
Arguably the most well-known financial metric when it comes to investing is the price-to-earnings ratio, or also called the P/E ratio. The price-to-earnings ratio is the price of a share divided by its earnings-per-share (EPS). You can look up the P/E of a stock on most financial research platforms like for example, Yahoo Finance or Morningstar.
In theory, it does make more sense to buy stocks with lower P/E ratios, because you are essentially paying less for more earnings. However, stocks usually have their current P/E ratio for a reason.
For example, when companies are expected to grow rapidly in the future, investors are willing to overpay for the future performance of a business despite its current earnings, which results in a high price-to-earnings ratio for their stock. Examples for companies with high P/E ratios would be tech giants such as Facebook or Amazon.
Is the Company Growing Consistently?
A company that has been growing on a consistent base is likely to do as well in the future. Therefore, it might be a good start for you to pick stocks that are showing increased revenue and earnings over the past 5 to 10 years, as this indicates that the company is financially stable and doing well over time.
Stock prices are oftentimes very susceptible to the company’s earnings, which concludes that increasing revenue is one of the essential factors that drive up stock prices. Besides that, you should also look for other steadily growing numbers like
- Dividends, which are cash payouts to investors, can also be a sign for a company in good financial health
- Decreasing debt. Debt is necessary for every business to raise capital, but too much debt can be dangerous for companies in times of financial hardships.
- Free cash flow, which is the net amount of cash and cash equivalents within a business. It essentially shows how much money a company has left after paying dividends, current debt, and buying back stock.
How Well Is the Company Doing Within Its Industry?
Another essential information to look into is how the company performs compared to its competitors within its operating industry. Some questions that should be asked are:
- How big is the company within its industry?
- What makes the company better than its competitors?
- How can the business protect itself from the competition?
It is also important to recognize and avoid bad industries that aren’t likely to have a sustainable future. Most of the time, you should avoid investing in stocks that are operating within dying industries, even if they seem as solid businesses selling at attractive price points. The negative future outlook of their industry is often the reason why they are undervalued by the market.
For example, technical progress has shifted consumers from traditional media and newspapers to online streaming and social media, which meant a severe decline in revenue for companies that were operating in those industries.
Companies that are completely dependent on the consumers of dying industries are most likely to perform really bad if they aren’t able to transition their business model fast enough. This is why avoiding business within dying industries in the first place is the better option.
Would You Be Willing to Own the Stock in the Long Term?
Especially if you are a beginner, you shouldn’t count on the small growth stocks that may have the potential to become the next Amazon, Facebook or Tesla because most of the startups and small-caps are certainly going to disappoint at the end, and you probably don’t want to get discouraged at the start of your investing journey with a severe loss.
This is a common way how beginners lose money right at the beginning of their investment horizon and immediately perceive investing in the stock market as too risky and dangerous. Even if you might hit a lucky shot, in the beginning, it’s not likely that you will continue like this on the second or third stock pick.
Investing in small growth stocks like penny stocks is generally rather considered as speculating and not fundamental investing. Chances for you to consistently achieve positive returns are not only quite low but can also be extremely risky.
The most successful investors like Warren Buffett have consistently beaten the market for most time in their careers by steadily looking for great investments with a long-term mindset.
In fact, Buffett even prefers to buy companies that he believes could be owned forever.
“Our favorite holding period is forever.”
When you finally found a great company, which is additionally priced at a bargain of its value, you won’t have to deal with its short-term fluctuations in the first place, because you already assessed that chances are pretty high that your chosen stock is going to provide great positive returns in the long run.
Stocks may seem complicated to analyze at the beginning, but after some time of learning and practice, you will become better and better in understanding financial numbers and metrics and what they mean for a company. Nowadays, it doesn’t take too long to find great companies. However, finding them at an attractive price is the more difficult part.