Now that you have decided to invest in stocks, I am assuming you are familiar with the Basics of the Stock Market. Investing in stocks is certainly the most rewarding investment around the world, in terms of wealth creation. Analysing a stock or a business is not a complex process as it seems, it has a lot to do with understanding the business performance in every aspect. In this article I will discuss on how to choose good stocks. And the 5 most important steps to consider in the process of picking the best stock.
Investor’s Goal While Choosing Good Stocks
Before investing you might have an opinion on the market based on how the overall economy is performing. Such as, what stocks you want to buy and what would you do at the time of crisis? it is wise to make your intentions clear beforehand. If you have not done it you might be a market victim where you might end up square off everything at the time of depression. The point is it is not the market or the stock brokers that make an investors fate but, it is just the investor himself.
It is important that an investor should decide why he wants to invest. One must invest only the amount which he can afford to lose. However, this should not affect his daily life in the future. In other words, if a person is trying to invest some money which he saved for his education or sisters marriage or any other important event then that might be a bad idea because markets are unpredictable. Ideally if a person is earning money and wants to invest 5% of his income without no change would occur in his daily foreseeable future.
Type Of Investors
People around the world invest for various reasons which depend on multiple factors. Different types of investments are recommended for different types of investors, as task of how to choose good stocks is different for different people. In general there are 2 types of investors one is conservative investor and other is aggressive investor. Conservative investors are those who want to make sure that their investment is safe. In simple words they are attracted to less risk and less return on the other hand aggressive investors are more inclined towards higher risk and higher return.
Conservative way of investing is not to lose the capital invested. However, there might be lower returns and prices for goods and services are always appreciating which would be a challenge to beat inflation. If you are someone who is not very concerned with returns but requires capital guarantees then you are a conservative.
Aggressive way of investing is to maximise capital appreciation. However, there is a risk of capital loss as the risk is higher. If your risk appetite is higher and you have a hunger to grow your wealth then an aggressive way is best.
Why Is It Important To Choose Good Stocks?
If I may ask you a question, How long does an average person take to buy a house? Let me explain why. Firstly people should consider buying a stock is similar to buying a property or asset because this is a piece of ownership in a business just like ownership to the property. When someone is planning to buy a house there is a process followed largely. They call someone for valuation based on area, checking the property for any damages, leaks, breakage. If there is any demand for the rentals, future saleability and financing options.
Astonishingly, people don’t do their homework before buying stocks. No wonder why people lose money on stocks and make money in real estate. If you invest days investigating the property, on the other hand spend minutes deciding which stock to buy, obviously there is no proper analysis.
One of the primary objectives to pick the best stock is to get great returns. Equity stocks provides exponential returns for being right and accepting uncertainty, risk over a period of time For example if a stock is appreciating on compounded annual return of 11% it becomes 3.5 times in 10 years on the other hand if the stock appreciates on an average compounded annual return of 21% the stock appreciates approximately 10 times in 10 years of the original investment.
5 Steps On How To Choose Good Stocks
For many decades blue chip companies were considered as safe and small cap companies were considered riskier but gone those days. If things are right a small cap can grow manifold similarly if things go south a blue chip can drop drastically. In order to choose good stock one needs to follow a few steps.
Understanding The Business And Industry
If you want to understand a stock, you have to understand the business behind the stock. You can find winning stocks everywhere in our day to day life. For example, if there is a popular food product which you have been consuming for decades and you never thought about researching about the company such as Maggi. Maggi is owned by Nestle which appreciated 5 times in the last decade. Understanding the business makes you feel confident and gives a clarity on how they are making money in the market.
If a group of companies are involved in the same kind of business then they form an industry. Comparing with peer companies gives you a clear picture on performance of the company in industry. Asking questions like, What is the market share of the target company? What are the future prospects? This may provide investors with a better understanding of the position of the company in a specific sector.
Earnings
People might think every now and then to invest in what is hot at the moment but ultimately earnings and assets will decide the stock price in the long run. There are so many aspects which decide earnings growth. Companies’ earnings growth depends on the type and age of the company as well. For example some are fast growing, some are slow growing companies. Earnings and stock price have a very special relationship. Although stock price might deviate from earnings due to various factors in the long run it always aligns with the earnings.
When it comes to owning a piece of ownership in a company, I would say reading financial statements is one of the best ways to learn about the company. Earnings and assets are the most important reasons which decide the destiny of the stakeholders. If a company has future earning potential and past consistent earnings record it is a great start to dig deeper. If you have analysed a company based on its earnings and the earnings seems right, although stock price does not reflect the financial statements. However, the market will correct itself after a while if the fundamentals are solid. In the short term markets are determined by various factors such as investor psychology and market news. Often market corrections happen after a while to make things right.
Financial Ratios To Choose Good Stocks
These ratios are created by using the numbers on the financial statements such as balance sheet, income statement to provide meaningful information regarding the companies performance and position. They also helps investors to analyse the liquidity, profitability of a company and provides numbers to compare with peer companies. Some of the famous ratios used in the investment industry are PE (Price to Earnings) ratio, Debt to Equity ratio, Gross profit margin.
Liquidity ratios provide information regarding the company’s potential to settle its long and short term loans. For example Current ratio, Cash ratio, Operating Cash Flow ratio. On the other hand Leverage financial ratios calculate the level of debt of a company. For example Debt to Equity ratio, Debt ratio.
Efficiency ratios provide information about how well the company is utilising the resources and capital provided. For example Asset turnover ratio, Inventory turnover ratio. On the other hand profitability ratios are provided to observe the companies ability to generate profit. For example Gross profit margin, Operating profit margin.
Efficient Management
Management plays a major role in companies’ destiny and growth. Management has the power to administrate and set the vision of the company. They are responsible for making policies and implementing them. Under bad management, even good business can get on a wrong track. It is worthwhile to analyse the management of the company and their future plan for company growth.
Management efficiency can also be determined through financial ratios and financial statements. By looking at the figures such as inventory days, receivable and payable days. Which provides information regarding how well the management is able to maintain the working capital of the business. On the other hand, management can be judged through financial ratios, if they are capable of maintaining the debt levels and utilisation of capital and resources properly.
Demand In The Future
Analyse the future prospects of the company and business. Reading annual reports published by the company’s management states the scope and vision of management for the future. The stock makes sense only if the business is going to be relevant in the future. If the business or goods has no demand in the future then what is the point in investing in such a business?
Stock picking is not science it is an art. Buying a stock is nothing less than buying a property. However, people spend very less time on analysing a stock comparatively. As this is a digital era, information is at our figure tips, there is no loss on researching the company and its financials before investing hard earned money. Choosing good stock takes time and effort but provides exceptional wealth appreciation in the long run accepting uncertainty and risk. However, learning how to analyse a company and how to choose good stocks makes it a calculated risk.