Investing in the right stock can be extremely rewarding for shareholders. While more risky than holding a diversified group of stocks through a low-cost index fund, identifying a winning stock can produce gains that significantly outperform market averages such as the S&P 500.
So, how do you go about choosing which stocks to invest in? Here’s what investors should know about how to pick a stock.
How to pick a stock: 5 key steps
1. Identify your investing goals and what kind of stock you’re looking for
Before you start buying and selling individual stocks, you’ll want to think about your goals and why you’re investing in the first place. If you’re young and saving for retirement, you may be interested in finding a company that has a lot of growth potential that can help you reach your retirement goals.
If you’re already retired, you may be more interested in generating income from a stock in the form of dividends. A retiree may be willing to accept a company that’s growing more slowly if it means they earn a decent yield from their investment.
It’s also worth spending the time to understand your own risk tolerance. Investing in individual stocks is risky and may add volatility to your portfolio. Ask yourself how you’d feel if a stock you bought dropped 20 percent or more in a single day. While not a common occurrence, those sorts of declines do happen, and it’s important to think about how you might react ahead of time.
2. Find a company to research
Stock ideas can come from just about anywhere, but it can be helpful to start with a company that you have some experience with. Maybe you ate at a restaurant with a unique concept that you think can expand, or the software your organization uses to track expenses is simple and saves time. If a company is publicly traded, you can buy its stock.
Think about how many people were regularly buying books and other items from Amazon.com in the early 2000s and saw how convenient online shopping was. If they’d bought the stock back then, they would have been richly rewarded.
We all interact with companies constantly throughout the day, so pay attention to which ones are publicly traded, because it could lead to your next investment.
3. Learn about the company’s business and potential competitive advantages
Once you’ve identified a stock you’re interested in, you’ll want to take the time to understand the company’s business. If you’re a long-term investor, it’s important to remember that you’re not just picking a stock that rises and falls each day, but rather a business that will produce earnings over time that support the stock’s valuation. The results of the business will largely determine the stock’s performance.
Here are some key questions you’ll want to answer as you research a company:
- How do they make money? Do they make money?
- Are they growing revenue? How quickly?
- What are their profit margins and how have they changed over time?
- Why do customers buy from them and not a competitor?
- How much debt do they have?
- What risks does the business face?
New investors may be surprised to find that some companies don’t generate net income at all, but rather report losses. Some of these companies may end up earning profits in the future, while others will go away because of a flawed business model. But a company needs to generate cash at some point in order to justify its long-term value.
As you’re conducting your research, pay attention to any signs that the company has a competitive advantage, or a way for it to protect its market position. Many companies can achieve success for a brief period of time, but without a competitive advantage, new competitors can arrive to steal their success.
4. Determine what you think the stock is worth
Coming up with a fair value for the stock can be complicated, especially if you’re just starting out with investing. The formula for what a company is worth is actually fairly simple. You add up the cash it will produce in its remaining life and discount it back to the present at an appropriate interest rate. It’s predicting the future that is not as simple.
There are ratios that may help in your analysis. The price-to-earnings ratio is one of the most common tools used on Wall Street for valuing a stock. All else being equal, companies with high growth, high profitability and high predictability garner higher P/E ratios than slow-growing, cyclical businesses.
It may be useful to look at a stock’s current P/E multiple and compare it to the rest of the industry or its historical range. If the multiple is depressed relative to its peers or history, it may indicate a good time to invest. Conversely, if the multiple is high relative to its peers or historical level, the stock may be overvalued.
Check out Bankrate’s list of financial ratios every investor should know.
5. Make a decision to buy, sell or wait
Once you’ve completed your analysis and have an idea of what you think the stock is worth, you can make a decision about whether you want to invest. One idea to keep in mind as you’re making your decision is the “margin of safety” concept.
Many of the best investors, including Benjamin Graham and Warren Buffett, have advocated for using a margin of safety when you invest. The idea is that you should be conservative in the price you’re willing to pay for a stock relative to your assessed value. You could be wrong in your analysis or there could be changes in the business that lower its value. Buying with a margin of safety gives you another layer of protection.
You may also find that after your analysis there isn’t much of a difference between where a stock trades and where you think it should be valued. If you like the company and its prospects, you can continue to follow its results and see if an opportunity presents itself to purchase it at an attractive price. As Buffett’s late business partner Charlie Munger once said, “The big money is not in the buying and the selling, but in the waiting.”
Bottom line
Investing in individual stocks can lead to meaningful profits if done well, but it also comes with significant risks. You’ll need to have an understanding of finance and accounting to interpret a company’s financial statements, and be able to analyze its business prospects.
If you aren’t well suited to pick stocks, the good news is that you can still do quite well as an investor. Low-cost index funds that track market averages such as the S&P 500 are easy to purchase and give investors access to a diversified portfolio of some of the best companies in the U.S.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.
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