Let’s be real: picking stocks wisely can be intimidating. After all, no one likes to have “buyer’s remorse” when a seemingly good stock pick plunges into the red.
Some might say losing money on stocks is just a part of the game. That’s somewhat true. But far from being a guessing game, picking stocks wisely involves analysis, strategy, and some sound investing principles. With the right method to evaluate stocks, you’ll find yourself saying “no” to bad deals far more often — and saying “yes” to those valuable opportunities that others overlook.
How can you pick stocks wisely? Below, we’ll help you start evaluating stocks.
Choosing stocks wisely: how to evaluate stocks
Unless you were born with a knack for picking valuable stocks (aka, Warren Buffett), you’ll have to learn how to “see” them. While a lot goes into professional stock picking, these six steps will put you on the right track.
1. Start with companies you understand
Peter Lynch, Warren Buffett, Ronald Reed — history’s most successful investors have amassed millions (billions even) on the basis of one simple principle: invest in companies you understand, and avoid those you don’t.
It’s common sense, right? As a beginning stock investor, you will have a far easier time evaluating companies whose products, business model, and industry you’re already familiar with. If you’ve worked in IT your whole life, you’ll most likely have a deeper intuition into certain tech companies than, say, retail companies. Conversely, the person who works in retail will probably make a better retail investor than a techie, simply because they have personal knowledge of the retail industry.
That doesn’t mean you have to limit yourself to companies you’re already well informed about. If you’re curious (or downright obsessed) with a certain industry, say, green energy, your interest may motivate you to learn more about each company, helping you pick a great stock.
But don’t just invest in companies “just because.” That’s how you lose money. If everyone tells you to invest in a company that manufactures semiconductors, but you have no clue, nor interest, in what a semiconductor does, you’re probably not going to make an informed buying decision. Unless you’re willing to put in the time to research and learn about the semiconductor sector, you might be better off skipping it.
So, as a starting point, invest in what you know. Look at your hobbies, areas of expertise, and the products you’re already buying. Somewhere in that mix is a great company for you to invest in. Now, you just need to dig a little deeper to find out which is the best long-term investment.
2. Identify companies with strong competitive advantages
A competitive advantage is a company’s ability to stand above its rivals with desirable traits that keep customers loyal to its products or services for a long time. Some call competitive advantages “wide moats,” since they defend a company’s market shares from competitors.
Most people know “intuitively” that companies have competitive advantages, though they may not know what these advantages are called. Typically, competitive advantages will fall into one of these four buckets:
- Cost advantages: A company with cost advantages offers good quality products at lower prices. These companies often have a more efficient production process or a cheaper way of distributing products. They may outsource labor to another country or use artificial intelligence to cut labor costs altogether. Either way, their prices are better than their competitors.
- Network effects: In simple terms, the “network effect” happens when a company’s product or service becomes more and more valuable as it gathers more and more users. Think of Facebook or any social media platform. The more friends and family who use Facebook, the less likely people will leave for something else. Other examples include Slack and the learning module Docebo.
- Intangible assets: A company with a household name or a strong brand has intangible value. It’s competitive advantage is the trust it has established. In many cases, companies with intangible assets can charge more for its products, even when a cheaper substitution is available (think Coca-Cola, or every branded cereal on the market). Patents are also considered intangible assets.
- High switching costs: A company may also have an advantage over others for the sheer fact that consumers don’t want to pay the cost to switch to an alternative. These costs could be in lost dollars, time, or even energy. Banks typically benefit from this competitive advantage, as do some technological platforms such as Shopify.
3. Analyze a company with key metrics
Competitive advantages will help you spot potentially great companies from a long distance. But, in order to truly know if that company is a stud or a dud, you have to dig a little deeper.
That’s where metrics come in. Metrics can help you see if a company’s stock is worth the price, undervalued, or a bad investment. Though they require some time and practice to learn, metrics can help you dig deeper than the surface, helping you decide if a stock will perform well over the long-term.
To help you choose stocks wisely, here are some key metrics to add to your belt.
- Price-to-earnings (P/E) ratio: The P/E ratio helps you understand how high or low a stock’s price is when compared to a company’s annual earnings. In other words, P/E calculations help you decide if a stock is over or undervalued.
To find it, simply take a company’s market capitalization and divide it by its annual earnings. In general, a low P/E ratio could mean the stock is undervalued, whereas a high P/E could indicate the stock is overvalued (possibly a growth stock).
- Price-to-earnings-growth (PEG) ratio: Again, a P/E ratio (above) helps you compare a stock’s price to a company’s earnings. But P/E ratios overlook one important aspect of certain companies: future growth. That’s where the PEG ratio comes in. The PEG ratio compensates for the P/E ratio’s shortcomings by taking expected growth numbers into consideration.
To calculate it, take a company’s P/E ratio and divide it by its expected growth earnings. Like the P/E ratio, a low PEG could mean the company is undervalued, whereas a higher PEG could mean it’s over-valued.
- Price-to-sales (PSR) ratio: Another shortcoming of P/E ratios is that it measures a company’s earnings. For many growth-oriented companies, who haven’t reached profitability yet, measuring stock prices by its earnings may not be helpful. Instead, it may be better to analyze growth companies by their revenue. The PSR ratio helps you do that. To arrive at a PSR number, divide a company’s market capitalization by its annual revenue.
- Price-to-book value (P/B) ratio: A company’s “book value” tells you the difference between a company’s assets and its liabilities. The P/B ratio, then, helps you compare stock prices with a company’s assets. To calculate it, simply divide a stock’s price with its book value per share.
- Debt-to-EBITDA ratio: Finally, you shouldn’t just look at how much money a company earns or is expected to earn. You should also take into account how much debt it carries. A good metric to help you analyze a company’s debt is it’s debt-to-EBITDA ratio. To find it, look on a company’s balance sheet and locate both its debt and its EBITDA (earnings before interest, taxes, depreciation, and amortization). Then divide total debt by its EBITDA. The higher the ratio, the more debt that company is carrying, which could be too risky for you.
These metrics, along with others like them, will help you independently value a stock, which is arguably the most useful skill you can learn as a stock investor. While the value of some stocks is equal (or close) to their companys’ intrinsic values, others are valued below or above what their companies are actually worth. These metrics help you see for yourself if a stock is worth its weight, or if you should wait to buy it.
4. Look at the company’s past returns
A company’s historic returns are a review of its ups and downs stemming back to the year the company went public. You might be familiar with the classic graph showing a squiggly line rising and falling over the years. That, in a nutshell, is an historic return.
Historic returns can help you understand how well (or poorly) a company performed during economic downturns and recessions. It can also help you compare the company’s performance against that of a broader market index, such as the S&P/TSX Composite, which will help you see if the stock’s ROI has beaten the market or paced behind.
One word of caution with historic returns: past performance doesn’t predict future performance. Just because a company crushed it for twenty years doesn’t mean it’s going to match its gains for the next twenty years. Instead, historic returns help you understand how far a company has come, as well as how well the company endured unfavorable market conditions.
5. Consider the stock’s place in your overall portfolio
Once you’ve selected companies you understand (with strong competitive advantages), valued its price with key metrics, and analyzed historic returns, it’s time for the last step: deciding if the stock has a place in your portfolio.
Recall that a well-balanced portfolio includes stocks from numerous sectors (financial, technology, energy), each with different value propositions and varying market capitalizations. If the stock you’re evaluating fills a gap, increases your exposure, or hedges against market volatility, it’s probably a wise pick. Conversely, if your portfolio is made up of solely one kind of stock (technology, for instance), and the stock you’re considering isn’t any different, you may want to branch out to other industries.
But doesn’t that contradict the whole “invest in what you understand” guideline? A little, yes. But keep this in mind: the most successful stock investors never stop learning. You start with what you know, sure. But then, as you get more comfortable with investing, you take what you’ve learned and apply it to other sectors. That, in essence, is how you build a portfolio of wisely picked stocks.
How to start picking your stocks wisely
In order to start picking stocks wisely, you’ll need a broker first. Fortunately, Canada has some of the best online brokerages for you to choose from, many with low trading fees and free resources to help you choose stocks wisely. Examine each one carefully — some will offer free trials on their platforms — and choose the one that will offer the best investing experience for you.
Once you have a broker, you can start scanning the market for different stocks. Though you’re fully equipped to value your stocks, keep in mind that the best investing approach is to maintain a long-term perspective. Day trading stocks, while profitable for some people, is extremely risky, and if you’re not careful you could end up losing a lot of money. Instead, look for companies that offer you long-term value. Then, keep your money invested for the long haul.
Finally, if you want to see stock analysis in action, stay up-to-date on our stock market news. There you’ll find stock analysis — including proper use of metrics — on companies you’re probably familiar with. By understanding how our writers think, you’ll ultimately learn how to think about stocks yourself.