Now that you’ve completed steps 1 and 2 and are ready to start investing, let’s start with the basics on picking stocks. The majority of my trades are based on technicals and statistics but today I’ll be discussing this from a more fundamental approach with only a minimal touch of technicals.
So what factors might you look into when deciding whether or not a company is a good buy?
1. Picking Stocks: The Income Statement
The most important thing for me is a company’s earnings statement. How well is company doing each quarter? Are they showing a gradual increase in profit? And if not profit, at least revenue?
For example Facebook was showing losses every quarter from its IPO for a year until they finally showed signs of profit. That’s when the stock moved from an $18 low in early 2013 to a steady incline and is now trading around $74.
Another example is Twitter who’ve been reporting a loss every quarter even in its most recent earnings report. In Q4 of 2013, it reported a revenue of $243 million (116% increase versus last year) but a net loss of $511 million. In Q2 of 2014 revenue had increased to $312 million with a net loss of $142 million (124% increases versus last year). With these reports, although they are losses, show some improvement in the company.
You’ll want to pick a company that is successive growths and base how well it’s doing each year. Is it inclining or declining? If it’s not improving its business every year, then you may want to reconsider.
2. Picking Stocks: The Balance Sheet
Next up is the balance sheet, the core of any entity’s fundamentals. What is the asset-to-debt ratio? Is their asset column growing? How are its liabilities and long-term debt? Are they in any lawsuits that could impact future liabilities?
For long-term debt, looking at 0-4 years to pay back their liabilities is a good thing. Of course the shorter the better.
3. Picking Stocks: The P/E Ratio
The Price-to-earnings ratio. You’ll see this term get thrown around a lot when reading analysis reports for picking stocks. For growing companies, you should expect to see at least 20+. If it’s lower in the 10s, this may mean that the investor’s perception of the company is that it’s not growing, but it may be an undervalued stock that has potential. Do research on these as many times you will need to compare a stock’s P/E ratio to others within the same industry.
4. Picking Stocks: Checklist — Other Factors
The following checklist for picking stocks is based off Security Analysis: Principles and Techniques
- Net Income Growth: Look for growth, Year over Year, Quarter over Quarter. This can easily be gathered from a company’s earnings reports.
- EPS Growth: Look for an upward trend. If net income is decreasing while EPS is increasing, there could be financial engineering.
- Average COGS: The Lower the better.
- Average Gross Profit: Looking for consistency and high. GP > 40% indicates durable competitive advantage; GP < 20% indicates competitive industry.
- Average R&D: How much are they spending on R&D? Lower is better. R&D / Gross Profit < 5% is good, greater than 30% could be bad.
- Cash Flow: Cash flow is good. Look for high levels of cash flow. Low liabilities and low debt is good. Companies in financial lawsuits may be in trouble in this area.
- Average Inventory Turnover: High is good i.e. sold out Apple iPhones or waiting list on Tesla Model S.
- Inventory vs Net Income: Looking for a corresponding rise.
- Long-Term Debt Ratio: In financial accounting, this corresponds to a company’s long-term liabilities. Anything longer than 1 year is considered long-term. The sooner the better. Look for less than 4 years.
- Debt to Equity Ratio: Want less than 1. D2E < 0.8 could indicate competitive advantage. If ROE is high, make sure it is not because D2E is high.
Picking Stocks: The Technicals
How are its technicals? Is it overbought? Oversold? Check the RSI Indicator for signals like that.Stocks at its all-time-highs might be a little expensive to buy into so you might want to wait on a retracement.
Where is it on its 200 day moving-average? A stock doing well will remain above its 200dma which is one of the strongest lagging indicators of a stock’s strength.