By David Robinson, CFP
Stock investors face a tough challenge in choosing where to invest. Reviewing the massive amount of data available on public companies is vital for assessing the quality of companies and determining whether they’re suitable for their portfolios. But, it can be an arduous process.
When you're evaluating something like bonds, the overriding consideration is credit quality. With stocks, there’s no such silver bullet. So individual investors interested in buying equities are faced with a much tougher task: performing personal due diligence or, if they have advisors, evaluating their recommendations.
Developing a simple set of criteria to follow for evaluating stocks can make the task much less stressful.
Choosing Stocks: 5 Key Considerations
Decades ago, the problem for individual investors was getting enough information without buying costly subscription services. Thanks to the internet, investors now have access to free, real time data at the click of a button.
The challenge lies in selecting the right information for assessing a specific stock and evaluating it correctly. The process of selecting what stocks to invest in can be simplified by using five basic evaluative criteria:
1. Good Current and Projected Profitability
When choosing stocks, it's important to consider a company's financial fundamentals, including earnings, operating margins and cash flow. Together, these factors can paint a reasonable picture of the company's current financial health and how profitable it's likely to be in the near and long-term.
On the earnings side, investors should consider how stable those earnings are and how they're trending. Higher operating margins are typically more favorable than lower operating margins, in terms of measuring how efficiently a company operates. Reviewing the company's cash flow figures, specifically cash flow per share, is helpful in gauging profitability. It's also a way to assess whether a stock is over- or undervalued. (See also: How to Choose the Best Stock Valuation Method.)
2. Favorable Asset Utilization
Favorable asset utilization is the ratio of revenue earned for each dollar of assets a company owns. For example, if a company has an asset utilization ratio of 40%, it’s earning 40 cents for each dollar of assets it owns. Different ratios are favorable in different industries. Similar to operating margin, the asset utilization ratio is a way to measure efficiency over time.
3. Conservative Capital Structure
Capital structure refers to how a company funds its business operations, using both debt and equity. A conservative capital structure means that a company characteristically marshals capital in ways that create enough short-term liquidity to cover operating costs, while also reserving enough finance expansion without significantly increasing long-term debt.
4. Earnings Momentum
Current or recent earnings, the fixation of many investors, are nothing more than snapshots of where a company is, or was, at a given point in time. To see where companies are likely headed, look for earnings momentum — the slowing or acceleration of earnings growth from one period to the next— as demonstrated by patterns.
Look for these patterns by examining earnings reports over the previous eight quarters, and reading analysts’ projections for future earnings. If a company posted its best earnings of the last five years, two years ago, and has been lackluster since, it may be under increasing competitive pressure.
5. Intrinsic Value (Rather Than Market Value)
Intrinsic value is determined by analysts using complex absolute and relative valuation models. Available to individual investors online, these figures are a way to cut through market buzz to get a handle on a stock’s real value.
In the short term, intrinsic value can vary significantly from market value, which is influenced by perception and behavioral investing factors. Ideally, you want stocks whose intrinsic value is higher than the market value, as this can suggest eventual price growth.
Ask the Right Questions When Choosing Stocks
While these guideposts are helpful, they won’t tell you if a stock is right for your portfolio. To do this, try to answer these questions:
- Is this company’s enterprise, industry and sector consistent with your asset allocation?
If so, even though it may be high risk/high potential reward, if you have 20 years until retirement you might make a higher volume purchase, proportionate to your overall portfolio allocation, than you would if you’re five years from retirement.
If you're retiring soon, you might want to make sure stocks you’re considering have low risk characteristics by company and sector—while evaluating whether instead to put this money into lower-risk assets such as short-term bonds, depending on your late accumulation-phase asset allocation. (See also: How to Make a Winning Long-Term Stock Pick.)
- Time horizons aside, are a stock’s risk characteristics within your personal risk tolerance?
Would a sudden steep drop in share price cause you to lose sleep? As equity portfolio gains balance out losses, losses in stocks purchased within the parameters of an appropriate asset allocation shouldn’t bother you. If you envision a steep dive in a stock you’re considering as likely to cause discomfort, you might be contemplating too large a purchase.
Picking winning stocks with great consistency is extremely difficult, if not impossible. That’s why we have portfolios, and why a sound asset allocation calls for diversification. Managing this process is the essence of equity portfolio management. At the heart of this management is the prudent selection and review of data when selecting stocks. (For more by this author, read: 5 Rules of the Road for Volatile Markets.)
This article was originally published on Investopedia.