A friend recently said to me that he wants to buy a stock for his kid and just hold onto it forever and let grow. He threw a few stocks and their prices out there but has not made a decision yet. When I asked how he narrowed which stocks to consider purchasing, he didn’t really have an answer besides these companies are huge.
And so it got me thinking how should someone pick a stock? What are the basic things to look at when selecting a stock? And how can you gain some comfort knowing it will continue to do well?
Well, it all depends.
Step 1: What’s Your Stock Investment Objective?
Understanding what you hope to achieve from your stock selection is a very important question. Apart from earning a return, the income option, your risk level, and preference to a particular industry are aspects to consider in understanding your objective.
Is it important for your stock to pay dividends?
If yes, then consider mid to large cap
If no, then consider small cap
Is it important for your stock to remain stable and not volatile?
If yes, then consider large cap
If no, then consider mid to small cap
Are you only interested in stock from a specific industry (e.g., banking, energy, technology, consumer goods, etc.)?
If yes, this narrows to only companies specializing in selling products and services you are interested in from an investment standpoint
If no, your whole spectrum is widened to include stocks in all industries
Step 2: Evaluating Stocks Which Passed Step 1
Once you have narrowed it down to a small handful of stocks (preferably five or less), you can begin evaluating each. Here are some things you want to evaluate for each stock – not in any particular order:
- Return on Equity – this is a metric supported by billionaire Warren Buffett. It determines how well an organization is using its earnings to reinvest in the business for its continuous prosperity. In other words, it is an indicator of how hard management is working on using the income generated from business to grow the business.
- Price to Earnings Ratio – this metric helps you assess if the stock is fairly priced based on how money the company is making. For example, AAPL’s P/E ratio is around 18. This means that an investor is willing to pay $18 for $1 of the company’s earnings. It also helps assess if other stocks in the same industry are more or less in demand based on their P/E Ratios. Finally, companies that have posted losses do not have a P/E Ratio.
- Other important financial ratios to calculate and consider are the Current Ratio (organization’s ability to pay its bills) Debt to Equity Ratio (how much of the organization’s operations are financed).
- Dividend – a distribution of earnings from an organization paid to its investors at set intervals. Sticking with AAPL, it pays a dividend of $0.63 per share on a quarterly basis. So if you own 100 shares, you can earn $252 per year in dividend income.
- Management – management that has been with the organization for many years may be a good indicator of stability in the areas of revenue and expenses. If your research finds that management, particularly senior management changes every few years, it could be a sign of risk in that not everyone within the organization or board of directors is focused on achieving the same objectives. There could be other factors in play too such as industry benchmarks or investor expectations not being achieved which may be driving changes in management.
- Risk – one way to measure risk would be to consider the debt to equity ratio above. If it is a high percentage (i.e., over 100%), there is more pressure for the organization to earn higher revenues to cover the debt. If this doesn’t take place, the stock value can be affected. Non-financial risks should also be considered if, for example, a business is introducing a new line of products or expanding to another region.
Stocks still may be the right way to go if you have the risk appetite and want to earn more income. Even people in their 70s continue to own stocks. In a way, they have benefitted mentally by enduring the ups and downs of the stock market for decades. As reported by Bloomberg, older investors are comfortable with the volatility associated with stocks since they have been invested in them for so many years.
When proper research is performed followed by a strategic selection, stocks can provide great returns and dividend income for years and even decades. They have historically increased over the long-term, of course, the S&P 500 Index serving as the key piece of evidence.
Step 3: Learn More About The Business Itself Before Investing
For this step, I’ll provide a simple example. Consider the stock Pepsi (PEP). It provides food and snacks all across the world. It’s a large-cap company that’s been in existence for well over 100 years and pays dividends, whose yield is around 2.73%. It has popular brands such as Lays and Gatorade. It has partnered with organizations such as the National Football League to provide Gatorade and had sponsored the halftime show for years.
Pepsi’s competitors include Coca-Cola and Dr. Pepper Snapple Group among others. The question to ask is do these companies yield favorable results from the evaluation metrics in step 2?
Pepsi has proven to be an established company with a long history. If it fits your investment objective from step 1, you are comfortable with the evaluation metrics in step 2, and have acquired knowledge about the business from step 3 that can lead to an informed investment decision; it may be a good investment for you. If one or more of the steps does not yield favorable results, it may not be a good investment for you. Either way, you’ll end up with a set of data and auxiliary information that’ll allow you to proceed as an informed investor.
Join The Discussion:
- Have I missed any key things you may review when evaluating a stock?
- What percentage of your portfolio is comprised strictly of stocks?
- Which metrics for stock selection are the most important for you?
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