How to Pick Stocks – The Basics

How to use price to earning (P/E) ratio for stock valuation and other fundamentals of picking stocks.
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So you want to start picking a few stocks to boost your investment program. Where do you begin after choosing an online broker?

Maybe you’ve owned mutual funds before, but now you’ve read about a particular company that sounds promising, or perhaps a friend has given you a hot tip on a stock. Picking individual stocks is very different from owning a diversified fund of stocks. For better or worse, individual stock picks may represent a larger portion of your holdings and could have a greater impact on your investment results.

The higher stakes that come with individual stock picking warrant some intensive analysis before you buy equity. Fundamental analysis essentially boils down to looking at an opportunity the way a business owner would, closely assessing the company and its financials.

Here are six fundamentals for picking stocks you can bring to bear when considering an investment:

1. Determine how news relates to corporate earnings

Interest in a stock often begins with a story: why such-and-such a company could be the next Apple, or why a fallen stock price represents an incredible bargain.

The first question to ask is how that story could translate into future corporate earnings. Do the business plan, market demand and cost of production all add up to future growth, or the recovery of sales that have taken a dip? Often the hot stories used to promote stock tips don’t stand up to that kind of scrutiny.

2. Assess the competitive landscape

Businesses don’t operate in a vacuum — there are competitors vying for the same market, and success can attract more competition.

Assess whether the company you look at has patents or other unique advantages that could allow them to sustain their competitive positioning. Be especially wary of industries where there are low barriers to entry or deep-pocketed competitors that might make it difficult to sustain an advantage.

3. Examine P/E ratios

A company may have all the ingredients for success, but if investors generally recognize that already, they may have driven the price up to a level that makes it hard for the stock to go much higher. Too much hype can make even a good company a bad investment.

Price to earnings ratio (P/E ratio), is a simple comparison between a stock’s price and a company’s earnings. This creates a context for a stock’s price. For example, two stocks may each have a price of $50 per share. However, if one has $5.00 per share in annual earnings and the other has $1.00, the first stock will have a P/E ratio of 10 while the second one has a P/E ratio of 50. All things being equal, that makes the second stock a lot more expensive relative to its earnings than the first one.

4. Understand the dynamics of a company’s life cycle

P/E ratio can give you a snapshot of a company’s valuation at single point in time, but earnings are a moving target. To account for this, consider how the stock’s price compares with where earnings are likely to go over the next few years. This depends very much on where a company is in its life cycle – is it a well-established business, or a fast-growing upstart?

For well-established companies, a common stock valuation technique is to look at price relative to earnings over the past ten years. This creates some historical context for the current stock price.

For newer companies, the key may be to project their future earnings growth and consider how the stock’s price compares to that growth. When considering future growth, don’t simply extrapolate past earnings into the future. Companies typically have faster growth rates early in their life cycles, but those growth rates are impossible to sustain as the earnings base and market penetration grow.

5. Consider economic cycle impact

Whatever the merits of a particular company, the economic cycle is likely to have some impact on its revenues.

When considering a stock, think about what phase the economy is in. A recession may mean that a stock’s earnings are unusually depressed and likely to rise when the economy recovers. If the economy is already several years into a recovery, think about what would happen to a stock’s earnings during the next recession, when the bull market ends.

6. Decide whether interest rates are a headwind or tailwind

Finally, interest rates can have an important impact on stock performance. Generally speaking, rising interest rates are a headwind for stocks – they suppress economic activity, and they also make stocks less attractive to investors relative to bonds. On the other hand, a falling rate environment can very favorable to stocks. Consider whether this context is a potential plus or minus to any stock opportunity you are reviewing.

Fundamental analysis is more complex than the pat stories you often hear on investment programs, and it should be. It’s important to spread your investments to include safe options, such as certificates of deposit (CDs) or money market accounts. Owning a stock means owning a piece of a business, and business decisions should have more depth than a 30-second sound bite.

About Author
Richard Barrington has been a Senior Financial Analyst for MoneyRates. He has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications. Richard has over 30 years of experience in financial services. He has earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the “CFA Institute”).