Beginner’s Guide To Identifying Stocks to Invest In
By: Costas Andreou
Tags: Introduction, Investing, Personal Finance, Stocks, Value Investing

Beginner’s Guide To Identifying Stocks to Invest In

Want to try your hand in the Stock Market but don’t know where to start?

You’ve made the decision to take the leap and invest some money in the stock market. Great! Step one done! You have researched the different brokerage firms and accounts and decided on the firm and type of account you need which hopefully has reasonable costs. Fantastic! You’re almost there.

Now it is time to actually invest in something, but you don’t know what! You think to look it up online but before long you realize that for every post you find to buy Apple, there is another one to sell! The world of stocks is simply too overwhelming at this point for you to invest it.

Maybe you gave up altogether, or maybe you just bought on the hottest tip and end up losing some money, or maybe you heard that the safest way is to buy and hold ETFs for the longer term and that’s what you have done. Either way, using the information you had at hand, you made the best possible decision under the circumstances.

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Luckily, we can change all that now. No, I am not going to tell you what to invest in; no, that’s not what I want to do. Teach a person to fish and all, I simply want to give you more information about the stock market which should hopefully enable you to make better decisions. Maybe you make money; maybe you learn something and you’re better prepared for round two.

The only thing I know about stock markets is that every time I get promoted, the market goes down — Peter Lynch

One thing is certain before you invest any money, you need to be aware that your capital will be at risk. The markets are cyclical (as the quote above points to) and they don’t always make sense — especially in the short-term.

Invest in what you know!

As a first step, when it comes to choosing stocks to invest in, the first thing you need to do is come up with a list of stocks you would like to know more about. Let’s look into how you come up with this list.

Unique Insight

So, you want to get started investing and you’ve heard that Tesla is the next big thing — should you invest in TSLA? Depends. Firstly, what do you know about cars and car sales? What about electric cars? Batteries? If you do not know much about it, then maybe this is not a stock you want to add to your initial list.

On the other hand, maybe you understand the electric cars market all too well and you have unique insights. In that case, you most certainly want to add TSLA to your initial list.

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Spot a Trend

Or maybe, you’re a sales assistant in a clothing shop and you start noticing a trend. Fewer and fewer people are coming into the shop to buy clothes, but more and more people are returning clothes to the store from online orders. You ask around for a bit of research, you talk to your friends and family and realize that they’re all starting to use online shops. A quick google search returns Zappos and ASOS as the leading e-retailers. Maybe add them to your list.

Doesn’t sound realistic? Okay; here’s a personal story.

What Are Your Friends, Co-workers Or Your Family Telling You?

My wife was an ASOS ‘prime member’, or whatever they call it. Every day, I’d come home from work and see an ASOS package. She’d try the clothes on that she ordered online, keep what she wanted and send the rest back. One day, from the corner of my eye, I notice that the bag is no longer black and white. I ask if ASOS is re-branding.

Oh no; that’s not an ASOS bag. ASOS’s things are not the best anymore. Everyone at work buys from Boohoo now, so I thought I would try them

Wait, what?! She just went from a prime member to switching companies! I better look into this Boohoo company! Long story short, I made 70% on Boohoo that year.

You found a company, now what?

So, you came up with a company or a list of companies that you think have some potential. What next?

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Be a detective

It is time that you put your hat on, get your deductive reasoning skills ready and time to go hunting. It is time to find out as much as you possibly can about the company that you have identified. The first thing you need to do is to identify the story. What is the story that will convince you to invest in this company?

Usually, the way to start is from the company’s financial results. The Chairman’s statement and the CEO’s remarks before the actual results will give you an insight as to what the company gets up to — you can usually find all of these on the company’s website under the Investors Relations section. You should also read the ‘About Us’ section of the website. Do you know how the company makes its money or is it too complicated?

If you can’t figure out how the company makes it money or what they are involved in, then I would keep away. As Warren Buffet put it:

I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will. — Warren Buffet

Hopefully, you read everything and it all makes sense to you. The company operates simply and you understand how it makes money. Great!

Predict the trend: What’s the story?

Now, what’s the story? You know how the company is being run and how it makes its money; do you think they will continue making money? If so why?

If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored. — Peter Lynch

If you can see a clear path on how they will continue to grow and expand the business, then it’s worth exploring further. However, if you cannot see the vision or see how they could potentially continue to expand, then this stock may not be the one.

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I have found a company with a good story and people like it — shall I buy it?

I wish I could tell you that you’re good to go. However, the hunt has just begun and we’ve only just scratched the surface. It’s time that we spend some time looking at the financials of the company.

By looking at the financials of the company, we are aiming to be in a better position to help answer two questions:

Is the company financially sound?

Is the company fairly priced?

Our scope here is not to become expert accountants and researchers, but rather understand the basics so we can at least get a better understanding. Let us then explore some basic, and yet important metrics that we can use.

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Is the company financially sound?

To help answer this question, we first need to raise and answer a few more.

Does the company have sufficient cash in hand to meet its short-term obligations? Does the company have a handle on its long-term debt? Is the company making any money? Is the company making any profit?

It is only when we are in a position to answer all of the above questions that we can begin considering the company as likely financially sound.

1. Short-term obligations

To help us answer whether a company has sufficient cash in hand to meet its short-term obligations, we can examine two financial ratios of financial liquidity.

Current Ratio

The current ratio attempts to measure whether a firm can meet its short-term obligations by comparing the firm’s current assets with its current liabilities.

Current Ratio = Current Assets / Current Liabilities

where the Current Assets include Cash & Cash Equivalents, Marketable Securities, Accounts Receivable, Prepaid Expenses, and Inventory. Current Liabilities include Short-term debt, accounts payable and accrued liabilities.

Anything above 1 will be desirable, but we will be looking for a Current Ratio of 2.

Quick Ratio

The quick ratio essentially compares a company’s quick assets (i.e. cash-like assets that can quickly be turned to cash) to its short-term liabilities.

Quick Ratio = (Cash & Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities

You would expect that at a minimum, this ratio needs to be one. Otherwise, the company could quickly find itself in trouble. Being the cautious investors that we are, I suggest looking for a Quick Ratio of 1.5

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2. Long-Term Debt

Once we are satisfied that the company appears to be able to meet its short-term applications, the next thing we need to figure out is the long-term debt. Looking at absolute numbers is not a useful metric. For a company making $2 a year, a $10 debt is substantial, whereas for a company making $100 is not. As such, we need a metric that will allow us to rationalize it.

Debt-to-Equity Ratio

Debt to Equity Ratio is a ratio that will allow us to figure out the company’s financial leverage.

Debt-to-Equity Ratio = Total Debt / Equity

The smaller the number, the better. I suggest looking for companies that have a maximum of 1.

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3. Gross Profit

The next thing we should look into — is how much money the company makes through sales. That is, how much money is the company generating if we take the revenue (money through sales) and subtract the cost of goods sold?

We are looking for a positive number. We want to make sure that the company is not selling goods below cost.

4. Profit / EBITDA

The next step in the process is to figure out if the company is making any money. To do that, we can look at either the reported Profit or EBITDA number. EBITDA stands for Earnings before interest, tax, depreciation, and amortization.

Once again, we are looking for a positive number. The larger the better. We are also looking for an increasing number year on year. We want to find a growing company.

Armed with a company that looks to be within our ‘potentially financially sound’ list, we can then move on to trying to understand whether the company is fairly priced.

Is the company fairly priced?

The first thing to understand on this topic is what we mean by a company being fairly priced. That is, is the price we are being asked to pay representative to the value that we will be receiving?

Price Is What You Pay, Value Is What You Get — Warren Buffet

To give you a quick example of this, think about a company that makes $1 a year. How much would you be willing to pay for their shares? Assuming they only have 1 share in circulation, then all the earnings would be available to that one share. So, how much money would you be willing to pay for it? What would a fair valuation look like?

One way to price a company would be to project earnings 20 years in the future (or however long you think they would be making money). You can also take into consideration future earnings growth. Then discount all those earnings to today’s value, and you could come to ‘fair’ value. Note, I said a fair value; not the fair value. Fair value is something subjective.

So, let us examine two quick ways to help us conclude as to whether a company is fairly valued.

P/E (Price per Earnings) Ratio

The first metric to look at when it comes to valuations could be the price per earnings ratio. The P/E Ratio can be calculated as:

PE = Price of Each Share / Earnings per share

Assuming we saw a PE of 20, that means, that if we were to buy a share in that company right now, we would be paying 20 times as much as they made in earnings last year. Needless to say, the lower the PE the better the valuation of the company.

Critics of the PE ratio will tell you that PE does not consider the growth rate of a company. That is, fast-growing companies will have a much higher PE ratio than slower growth, usually bigger companies.

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PEG (Price per Earnings Growth) Ratio

The PEG Ratio attempts to address the critique of the PE ratio in regards to growth. It also lends itself to be easy to understand, quick valuation ratio.

PEG = PE / Annual EPS Growth

The smaller the ratio, the better priced a company is. It is often thought that a PEG of 1 signifies a company that is fairly valued, and hence anything lower than 1 is considered fairly or undervalued and hence warrants further investigation.