Every investor should learn how to pick stocks before investing in the stock market. I am not talking about day traders. That is a different topic, which I will cover in the next topic. Right now I am focusing on investments that you want to make and hold for a long time.
Once you learn how to use these tools you will be able to compare stocks and be able to tell a good investment from a bad investment. Hopefully, this will save you some money along the way. When I started investing I did not know these tools, so I lost some money to stocks.
2 Types of Analysis
To answer the question of how to pick stocks you have to know that there are 2 types of analysis that you need to do before you put your money into stocks. They are called qualitative and quantitative analysis. Both of them are very important because when you know that the company does great things it also has to show that on paper with numbers, and when a company is great on paper it has to have great people and structure to prosper further.
Qualitative Analysis is a descriptive outlook on the company that can be observed. It is not set in numbers, so you have to rely on logic, gut, emotions, and most of all knowledge. When doing this analysis you look for trends that are going on in a particular industry or in the world. Common sources for it are news, management statements, and research analysts. It is recommended that you have a deeper knowledge of a company or industry before even going to it.
Quantitative Analysis is information about financial results. Your main source is a balance sheet, income statement, and statement of cash flows. In these 3 places you can find or calculate are the necessary ratios that you can compare to the market, industry, or other companies.
Qualitative Analysis
You might already have a lot of information about some of the companies because you work in a particular sector or industry, or maybe you directly use some of the company’s products. That is a great place to start. If you do not have knowledge of the industry that you are interested in at the moment then you must do a lot of research and read on the internet. If you do not want to do that at the moment then I suggest you do not put your money into it either.
Without knowing what the company does or how it is managed and how it is perceived by people you can answer the question of how to pick stocks.
1. Evaluate values, mission, and vision. When you are checking a particular company it is a good idea to check what the company values, what it wants to achieve, and how they imagine its purpose. Some companies might write some nice words on paper so, check if they actually do that. You can check by reading the news, or checking what management tells to the public. If they say one thing and do the other it is not a good example of a trustworthy company.
2. Use SWOT analysis. SWOT is an abbreviation of strengths, weaknesses, opportunities, and threats. You can do this analysis yourself and evaluate if the company is a good investment.
3. Porter’s 5 Forces. This analysis is used to evaluate companies position in its industry. The 5 forces are rivalry with industry, the bargaining power of suppliers, the bargaining power of consumers, the threat of new entrants, and the threat of substitute products. Once you do this analysis by comparing the company that is interested in its competitors it is quite clear which company has a better position.
4. Moats. Moats are the most important thing that can protect a company in a harsh market and even help it grow. If a company has a durable competitive advantage it is very unlikely that it will lose its value in the long term.
If you have heard about value investing that is promoted by Warren Buffet you know that moats have to be in your checklist of how to pick stocks.
- Low-cost and differentiated companies. Because the company dominates its current position against suppliers it can get better prices and thus make products cheaper. Companies can further their position by making good quality products at affordable prices. Companies that mass produce their products can achieve economies of scale where their manufacturing costs are much lower. It is a lot different if you manufacture 1.000 units or 1.000.000 units. Big companies can automate and robotize their processes to save money on their production.
- High switching costs. It is hard or expensive to switch from one product or service to another. For example, if you are a Gmail user would you willingly use outlook instead? It is quite hard to switch because you have to learn a new system and set up all the rules for emails from scratch.
- Network effect. When companies have an excellent network that is practically impossible for a new competitor to appear or at least it would cost so much that they would not even try. It can be an extensive distribution network used around the world or an electric grid for the utility industry.
- Brand. When customers have an attachment to a brand, they trust it. When you think about a product you automatically think of a brand. These brands can charge higher prices just because they are so well known. Companies that have a great reputation for their products or services can be carried far by their customers. Word of mouth is a powerful marketing factor.
- Secret. These companies have developed or created something that is protected by license. Usually, companies with this moat are drug development companies. It takes a very long time to develop drugs and they are protected by law for a lot of years.
- Government protection (Toll bridge). In some cases, governments allow monopolies or give money to companies that are of national importance. They do not care for competition that much, they just want some things done. In a lot of countries, utility sectors are protected by their governments, however, often governments also control the prices of these companies.
Quantitative Analysis
Moving on to the quantitative analysis as I mentioned before you will be relying on the ratios that can be calculated from the company’s balance sheet, income statement, or cash flow statements.
1. Compare ratios to the industry average and competitors. In order to understand if the current ratio is good for the company or not you will have to compare it to other companies. Ratios on their own do not matter much as they are often very different between different industries.
2. Some rations are more important for some industries than others. For example, inventory turnover is very important for companies that produce products but not as important for companies that provide services.
3. Some ratios are more important to some stock types than others. For example, if you are trying to evaluate a growth company you do not expect it to pay out dividends. So, all ratios associated with dividends are not important in this situation.
4. Focus on key ratios. There are hundreds of different ratios out there. You do not need to compare all of them. I will list only the important ones in this article.
5. Ratio categories. All of the ratios can be divided into a few categories: valuation (price), profitability, liquidity, Debt (solvency), and efficiency (operating). By doing this you can come across a lot of different scenarios. For example, you will find companies that have great prices, but their other aspects a very bad, so it also explains the low price.
Below I provide a table that you can save when you are doing an analysis of stocks. It helps you to answer the question of how to pick stocks.
A lot of the ratios do not have to be calculated. You can find many of them on Yahoo Finance website under the summary or statistics tabs. Some of them, however, you will have to calculate on your own. But you can find all the needed numbers under the financials tab. Yahoo Finance has an income statement, balance sheet, and cash flow statement in there.
However, I will provide the needed formulas so, you would understand these ratios better.
Valuation ratios
Valuation ratios help you to determine if the current stock price is fairly valued, undervalued, or overvalued and determine how to pick stocks.
Price to Earning Ratio (P/E)
To calculate you will need: an income statement, and the most recent stock price. You can look up these numbers also.
P/E = Price per Share / Earning per Share
It shows how much you pay for 1 USD of companies earnings. The P/E ratio range is different in each industry. In general, it is a good start if it is below 25. For some industries, it can be lower.
PEG Ratio
To calculate you will need: an income statement, and the most recent stock price. You can look up these numbers also, but it would be a good idea to do it yourself.
PEG = P/E ratio / Projected annual growth in earnings per share.
Potential growth is quite subjective, as analysts calculate potential growth. As you know they are as accurate as a monkey picking stocks with darts. So, you might want to calculate this yourself by calculating the growth of the most important numbers for the last 10 years. If it is below 1, then it’s a good value.
Price to Sales Ratio (P/S)
To calculate you will need: an income statement, and the most recent stock price. You can look up these numbers also.
P/S = Stock price/sales per share
The ratio can be used with companies that do not have positive earnings or companies that are not profitable yet. Like Amazon or Tesla was for years. The good ratio is 1-2. Below 1 is excellent.
Price to Book Ratio (P/B)
To calculate you will need: an income statement, and the most recent stock price. You can look up these numbers also.
P/B = Stock price / Book value per share
Book value per share = (Total assets – intangible assets – total liabilities) / number of outstanding shares
It shows what the company is worth if it sold its assets and paid all its liabilities. Often used by value investors and used when there are negative earnings. It might be hard to compare ratios with other companies as they might use different accounting rules. The good range though is 1-3. Below 1 is excellent.
Enterprise Value/Revenue Ratio
To calculate you will need: an income statement, and a balance sheet. For this one, you will have to calculate yourself.
Enterprise value = market cap + Debt – Cash and cash equivalents
Revenue = Total Annual Revenue (Sales)
Used for the early stage of the company or for high-growth businesses with negative earnings. You can use this ratio as an alternative to P/E, PEG, and EV/EBITDA ratios. I would say that this one is better than the P/B ratio because it ignores accounting issues. It is hard to compare companies that have different cost structures. I have to mention that the ratio ignores profitability and the generation of cash flow. Also, it is not suited when you want to compare different company phases (new company and old established company). The good range is 1-3. The lower it is the better.
Enterprise Value To EBITDA Ratio (EV/EBITDA)
To calculate you will need: an income statement, and a balance sheet. For this one, you will have to calculate yourself.
Enterprise value = market cap + debt – cash and cash equivalents
EBITDA = Earnings before interest + taxes + depreciation and amortization
The ratio is also called EV multiple. Can be used instead of P/E. It is harder to manipulate these numbers by accounting. The good number is below 10. Some say below 15 is also good.
Price To Cash Flow Ratio (P/CF)
To calculate you will need: a statistics sheet. For this one, you will have to calculate yourself.
P/CF = Share price / Operating cash flow per share
Operating cash flow per share = operating cash flow/share volume
How much cash company generates relative to its market value? Can be used instead of P/E as cash flow is less manipulated than earnings. A value below 10 is good.
Price To Free Cash Flow ratio (P/FCF)
To calculate you will need: a statistics sheet. For this one, you will have to calculate yourself.
P/FCF = leveraged free cash flow/share volume
More rigorous from P/CF ratio. It is kind of the same as the previous ratio but more exact. Bellow 5 is good.
Dividend Ratios
Dividend ratios are important for you if you choose to invest in income stocks and evaluate how to pick stocks. If that is the case you are looking for old established companies that have been paying dividends for at least 10 years without missing a payment. It is best if these companies increased dividends in the last 10 years.
Dividend Yield
To calculate you will need: an income statement, and a most recent stock price. You can look up these numbers also.
Dividend yield = dividend per share/price per share
Ratios show how profitable your investment will be from dividends. However, it is better to invest in companies that pay dividends consistently rather than in companies that have a higher dividend yield.
Dividend Payout Ratio
To calculate you will need: an income statement. You can look up these numbers also.
Dividend payout ratio = dividend / net income
It shows the percentage of profits distributed as dividends. Usually, it is set in the company policy, so keep an eye on that. Less than 50% is awesome, 50-60% is good, and 60-70% is okay. Compare this ratio to the industry. For example, Real Estate Investment trusts (REITs) are required to have high payout rates.
Profitability Ratios
These ratios are important to evaluate the overall health of the company and how profitable it is. The rations help to answer the question of how to pick stocks. Companies with low ratios have a high risk of going bankrupt when the bear market begins as it is likely that these ratios will fall. If that happens stock price is sure to fall.
Return on Assets (ROA)
To calculate you will need: an income statement, and a balance sheet. You can look up these numbers also.
ROA = NET income / Average Total Assets
This ratio shows how good is company at using money. The higher number the better, but compare it to competitors.
Return on Equity (ROE)
To calculate you will need: an income statement, and a balance sheet. You can look up these numbers also.
ROE = Net income / Average Stockholder equity
The ratio shows how good the company is doing per invested money. The higher number the better.
Profit Margin
To calculate you will need: an income statement. You can look up these numbers also.
Profit margin = Net income / Sales
The ratio shows how much money is left after costs. The higher the better compared to the same industry.
Liquidity Ratios
Liquidity is very important for investors who are evaluating value companies. These are some of the most important safety tools. This ratio shows how a company can cover its short-term debts. If the ratios are bad, however, companies can reduce expenses (cancel training, lay off people, etc.), sell assets, take on more debt to cover the short-term debt, and cut or eliminate dividends to cover the debt.
All of these solutions usually have an impact on companies’ share prices. So, be aware of the numbers, because the last step companies can do are going bankrupt. If that happens you will lose all of your money from that investment. These ratios are very important to answer the question of how to evaluate stocks.
Current Ratio
To calculate you will need: a balance sheet. You can look up these numbers also.
Current ratio = current assets / current liabilities
Assets = cash, account receivables, inventory, and other assets that are expected to turn into cash in less than one year
Liabilities = accounts payable, wages, taxes payable, and the current portion of long-term debt
The higher the ratio the better. But compare it to peers because the normality can be very different in different industries.
Quick Ratio
To calculate you will need: a balance sheet. For this one, you will have to calculate yourself.
Quick ratio = (Cash and equivalents + marketable securities + account receivable) / current liabilities
This is a more conservative ratio than the current ratio because you look at more liquid assets. Likewise, the higher the ratio the better and you have to compare it to peers.
Debt Ratios
Debt ratios are very important like liquidity ratios and can help you to answer how to pick stocks. Having too much debt can lead to serious problems and eventually bankruptcy. You should always check if a company covers its debt with 2 years of earnings or less. More than that increases your risk too much.
Debt To Equity Ratio
To calculate you will need: a balance sheet. You can look up these numbers also.
Debt to equity ratio = total liabilities / total shareholder equity
If the ratio increases the company becomes riskier and can bankrupt because it cannot meet obligations. If the ratio is low then the company can sell some of its assets to pay out debt if it needs to do that.
Interest Coverage Ratio
To calculate you will need: an income statement. For this one, you will have to calculate yourself.
Interest coverage ratio = EBIT / Interest Expense
The ratio shows how easily a company can pay its debt. If the ratio is less than 1 then it is bad.
Efficiency Ratios
Efficiency ratios show you how good management is doing. Companies that have good efficiency ratios usually have more cash, and less debt, and can invest their money into growth instead of stock that collects dust in a warehouse. These ratios are also crucial to answering the question of how to pick stocks.
Asset Turnover
To calculate you will need: an income statement and a balance sheet. For this one, you will have to calculate yourself.
Asset turnover ratio = sales / average total assets
Similar to ROA it measures how well a company uses assets. The higher the number the better. Also, compare it to peers.
Inventory Turnover
To calculate you will need: an income statement and a balance sheet. For this one, you will have to calculate yourself.
Inventory turnover ratio = sales / average total inventory
This ratio shows how many times a company replenishes its stock in one year. The higher number the better. It depends on the industry what is good and bad, so always compare this number the similar companies.
How to pick stocks?
- To pick stocks that you want to hold for a long-term strategy you have to do qualitative and quantitative analysis.
- Qualitative analysis cannot really be measured. You have to analyze what the company is doing.
- Tools that help to do the qualitative analysis are values, mission, vision, SWOT analysis, Poters‘ 5 Forces analysis, and analyzing moats.
- Quantitative analysis is done by analyzing financial numbers that can be found in companies’ income statements, balance sheets, and cash flow statements.
- There are 5 types of ratios for quantitative analysis: valuation (price), profitability, liquidity, Debt (solvency), and efficiency (operating).
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