10 SIGNS OF A GREAT STOCK
So, you’ve finally decided to start investing. But wait! With tens of thousands of investment opportunities to choose from, how do you go about actually selecting the best stocks? Here's a look at the 10 most important signs or fundamentals that you should consider before adding a company to your value portfolio.
1. Price-to-Earnings Ratio
The price-to-earnings-ratio (also known as the P/E Ratio or earnings multiple) divides a stock’s share price by its earnings per share to come up with a value that represents how much investors are willing to shell out for each dollar of a company’s earnings. This is one of the most valuable and best known fundamental ratios as it provides a measuring stick to compare prices across companies and gives us an excellent glimpse of a stock’s valuation. A high P/E indicates that the stock is priced highly compared to its earnings, and companies with a higher P/E therefore seem more expensive. A stock with a lower P/E ratio costs less per share for the same level of financial performance. Obviously, an investor would want to pay less for the same return which means that a company with a lower P/E may be a better purchase opportunity. However, keep in mind that the P/E ratio should not be compared across different industries. For example, banking stocks tend to have a PE ratio below 20 whereas a PE ratio above 50 is perfectly normal in the video gaming industry.
2. Debt Equity Ratio
Knowing how a company finances its assets is essential for any investor, especially if you’re on the lookout for the next big value stock. That’s where the debt/equity ratio comes in. This ratio gives us an indication of the proportion of financing that a company has received from debt (eg loans or bonds) and equity (like the issuance of shares of a stock). The share price of a company with higher debt is likely to be more volatile because the company can be affected by things such as rising interest rates.
It is important to research why the company is taking on more debt to better understand if that money is being invested wisely. Usually a company with a better debt/equity ratio than its competitors would be considered a lower risk investment as it will be better situated to handle more difficult times within the industry.
3. Free cash flow
You may not know this but a company’s earnings are rarely equal to the amount of cash that it brings in. As a result, a company could report huge revenue and profit increases for its latest quarter, yet have no cash on hand to protect itself should something unexpected happen (recessions, trade wars, fines, lawsuits etc). Free cash flow solves this problem whilst allowing a business to fund innovation, pay dividends, develop new products and survive tougher times. Put simply, this is the actual amount of cash the company has after paying all of their costs and expenses. An investor generally wants a positive, free cash flow as it’s often described as the single best measure of corporate financial health.
4. PEG Ratio (PRICE/EARNINGS GROWTH RATIO)
The PEG is a modified version of the P/E ratio that also takes earnings growth into account. This is calculated by dividing the stocks P/E ratio by its expected 12-month growth rate. A common rule of thumb is that the PEG ratio should be around 1. A relatively low PEG ratio indicates an undervalued stock and a PEG ratio greater than 1 indicates an overvalued stock. Checking the PEG ratio of a stock is very informative and a great way to find companies that may look expensive but are actually trading at a discount. As a result, we can get an understanding of the company’s earnings, growth expectations and whether the stock is trading at a reasonable price relative to its fundamentals. Like the P/E ratio, this metric varies from industry to industry.
5. Positive earnings surprise history
During earnings season, every investor looks for stocks that can beat market expectations. This is because the stock price of companies that miss or barely meet analyst expectations is likely to drop. Therefore, finding stocks that have the potential to surpass these quarterly expectations are an investor’s dream. The best way to do this is to look at the earnings surprise history of a company and see how frequently they post earnings greater than management and analysts had guided for.
6. Earnings Momentum
This looks at the percentage increase of earnings to see which companies are accelerating and is important to check as it allows us to see whether a company is improving year over year. Companies that are earning more money are far more likely to attract the backing of growth investors than those whose earnings are slowing down. This is because decelerating earnings or revenue may panic investors who could assume that the stock has peaked. More often than not, companies succeed when they are making money so the earnings momentum is undoubtedly one of the biggest driving forces behind stock prices.
If you are new to investing, I think you will be best off trading stocks in a sector that you are familiar with and narrowing potential investments down based on your own interests or experience. Obviously, familiarity alone isn’t enough of a reason to buy a stock, but prior knowledge can give you an edge over the pros and make it more easy and enjoyable to follow the stock and more likely that you will make smart investments.
Unlike professional money managers, individual investors don’t have the ability to drop by a company’s headquarters to speak to management before making investment decisions. Despite this, there are still plenty of ways to find out about the leadership of a stock that you are interested in. The website of a company often lists the senior management team, their background, length of tenure and the company’s history. It is important to look at this to gain an idea of the experience and stability of their leadership. It may also be a good idea to check whether management are buying or selling their own shares as this gives us an idea of whether those at the top are confident in their own product.
9. Moat/ Is the company’s competitive position sustainable?
The term moat refers to a competitive advantage that a business has over its competitors. This factor is important for long-term investors because a moat can be extremely useful for sustaining a company’s long term profits and protecting market share. Essentially, an economic moat can be any factor that enables a company to provide a product or service similar to its competitors whilst allowing them to achieve greater profits. A good example of this would be having a low cost advantage such as a company having access to cheaper raw materials than its competitors. Ideally, we want to see companies with wide economic moats as they are more likely to reside in profitable industries and have long-term structural advantages over their competitors.
10. Intrinsic Value
Intrinsic value refers to the value of a company or stock calculated through fundamental analysis without reference to its market value. In other words, by looking at a company’s cash flow, annual growth rate and net income, we are able to gain an idea of the ‘real value’ of a company and determine whether a business is over or undervalued. For new investors who are getting to know the markets, determining intrinsic value is a concept to consider when looking for well priced stocks that fit in with investment goals.
Disclaimer: All trading involves risk. Only risk capital you are prepared to lose. I am not responsible for any losses or damages that you may incur as a result of following advice given on this page.