[Fin Talk] Finding the Right Stock investing
By Arlyn Tan
Stock market can provide respectable returns ranging from 10-30% per annum when investors are knowledgeable of the interplay of fundamentals, technicals, and emotions. For the beginners and for those who wish to review the basics of stock investor, here are 5 tips on how to pick the right stocks.
1. Determine the type of investor you are.
When you are an income-oriented investor, the stock of choice can be those that provide good dividends regularly. These are companies that are classified as blue chip and are under the consumer staples and utilities sectors. Investing in preferred shares can also provide a reliable income stream since the preferred shareholders receive fixed dividends before any dividends are paid to common shareholders.
Investors who are looking for capital appreciation are willing to invest in growth stocks where they take more risks for bigger gains.
2. Understand the business of the companies that you buy.
When you buy a stock, research the sector, industries, and the competitors of the company. You can create a diversified portfolio to reduce the downside risk. There are 11 sectors: energy, materials, industrials, utilities, healthcare, financials, consumer discretionary, consumer staples, information technology, communication services and real estate.
3.Research on the competitive advantages of the company.
Warren Buffet refers to this as the MOAT, the business ability to maintain competitive advantage over its competitors in order to retain its profitability and market share. This refers to the ability to outperform competitors through strategies like low cost, size advantage, high switching cost, and intangibles (patents, brand). The longer a company can retain its MOAT, the better for the shareholders.
4. Determine the Fair Price of the Stock.
Warren Buffet shares price is what you pay & value is what you get. Profits from the stock market comes from finding the highest value with the lowest price. Here are metrics that would help in determining the valuation of companies.
Price to Earnings Ratio is a metric that shows what the market is willing to pay today for a stock based on its past and future earnings. The P/E ratio does not factor earnings growth. P/E ratios are useful in comparing companies in the same industry. The higher the P/E ratio of a company compared to a competitor, the more expensive it is. People would still be willing to buy a high P/ E ratio of growth stock because of the company’s ability to generate revenue in the future.
Price to Book Ratio is used to compare the net value of a company to the market capitalization. A P/B ratio of 1.00 means that the stock is trading at book value. The lower it is than 1 , the more it becomes attractive because it is selling at a price that is lower than its book value.
Debt to Equity Ratio helps investors to determine if the company is highly leveraged to finance its assets. A good D/E ratio depends on the industry and nature of business. Banking industries have a high D/E ratio. When comparing companies under the same industry, a high D/E ratio poses a higher risk to shareholders. A negative D/E ratio shows that the company has more liabilities than assets.
Discounted Cash Flow Modeling. It is a valuation method that uses the future cash flows, earnings and then discounts the time value of money. It calculates how much an investment is worth today based on the return in the future.
PEG Ratio Price to Earnings Growth Ratio shows the relationship of the company’s forecasted growth rate and the P/E ratio. It analyzes today’s earnings and the company’s growth rate in the future.
The formula is PEG = (P/E) / EGR where EGR = earnings growth rate over five years.
When comparing two companies, the one with lower PEG Ratio would have better value because it is trading at a discount.
Dividend Yield. The dividend depends on the company payout ratio as a percentage of earning and free cash flow.
5. Buy a stock within a margin of safety.
Take a 10%-20% off the target price as a margin of safety. This will allow you not to lose money when economic events do not become in favor of the company. Take 10% off the target price for companies with stable earnings, while take 30% off for smaller companies or a large company entering a new market.
When market fluctuations can be unnerving to you, your hard-earned money can still participate in the stock market through mutual funds and exchange traded funds. The pooled funds allow you to purchase small pieces of many different stocks with a single investment. The upside is the diversification which lessens your risk.
Stocks can form a valuable part of a portfolio. It can build your savings, protect your money from inflation and taxes, and maximize income from investments through dividends. With knowledge of the companies you wish to invest in plus understanding of the interplay of the different factors that affect prices, you will have a high chance of gaining profits from stock investing. As Benjamin Franklin would say, an investment in knowledge pays the best interest.
Arlyn Tan is a Strategic Wealth Consultant. She helps individuals and organizations on how to maximize the value of their money through risk, health & wealth management. Her mission lies in making sure that clients achieve 3 things. First, they reach their milestones on time with sufficient resources. Second, they protect them from the impact of economic losses secondary to unexpected events. The third and most important is that they enjoy meaningful and balanced lives.
LinkedIn/Twitter: Arlyn Tan