Picking the right stocks may seem like rocket science but it’s not. As with all things financial markets, it’s a matter of doing thorough research and finding ways to mitigate your risks while stock trading.
In this article, we’ll share three things to consider when picking individual stocks.
- Competitive advantage
Before deciding to invest in a given company, you need to assess whether it has a competitive advantage and how long that advantage is likely to last.
A competitive advantage can take many different forms, such as scale, costs and intellectual property. For example, Amazon has a clear advantage over competitors when it comes to the range and low prices of its products. It’s also an incredibly convenient service thanks to its delivery network and pick-up points – it may soon become even more convenient using delivery drones.
- The price of the stock
Once you have a list of companies you think have a strong competitive advantage, you should evaluate their current stock prices to determine if it represents good value. There are several important figures you can use to do this.
- Price-to-earnings (P/E) ratio: This takes a company’s share price and divides it by its earnings per share over the past year. A stock whose P/E ratio has fallen below its historic average is typically seen as trading at a good price, although there may also be good reason for this.
- Price-to-sales ratio: This metric compares a company’s stock price to its revenue. This gives you an indication of the value that investors are placing on each pound the company makes in sales.
- Dividend yield: This is another important figure to consider, especially if you’re focused on income. If a stock’s dividend yield is above average, it could be a sign that it’s trading a good price. You can check how safe the dividend is by comparing the total dividend payout to the company’s earnings and free cashflow.
- Safety margins
The stock market will always be unpredictable. So even with the most accurate calculations in the world, you can always be wrong. That’s why it’s vital you buy company stocks that are trading well below your estimate for a fair price. This way, you won’t suffer catastrophic losses if you valuation is wrong. Even taking as little as 10-20% off your fair price should be enough to protect your capital from the worst. You don’t need a huge margin of safety – but make sure you have one.
The bottom line…
Selecting good stocks isn’t rocket-science. It’s a case of finding companies with wide, defensible moats and whose stocks are trading at reasonable prices. Remember that nothing’s certain in the stock market and take appropriate steps to manage risk, and you’ll be well on your way to picking stocks like a pro.