How to choose companies for stock investment?

October 28, 2023

INDEX

The stock market is a popular place for investors worldwide, many of whom are keen to know how to make smart investment choices. In this article, we’ll discuss how to choose companies for stock investment.

Selection criteria for a company

Proximity bias

Many new investors tend to focus on large companies within their own country, such as British American Tobacco, Lloyds, Glencore, or NatWest. While these companies might have performed well or poorly in the past, this approach limits our opportunities. Sometimes we think, “I knew that company’s stock would rise, but I didn’t invest in it.”

Understanding basic screening methods can help us avoid investing in overvalued companies. Effective stock investing is about identifying companies with strong future growth potential that are not overly expensive at the time of purchase.

Valuation ratios

To make informed decisions, we should consider several important ratios. We should also know where to find this information and how to interpret it. Our aim is to invest at a reasonable price, minimising the risk of holding an overpriced portfolio.

It’s important to note that both large and small companies are publicly traded. Smaller companies often have greater growth potential, but they may also be more expensive relative to their earnings. Smaller stocks also come with higher risk compared to already established, mature companies.

To get a balanced view, compare a company’s valuation ratios with those of its industry peers and historical data. Future projections and target prices are also worth considering.

While many websites provide fundamental data for analysis, it’s usually more reliable to use a broker that offers the specific information you’re looking for.

What to take into account when filtering stocks?

There are many variables you could use to select stocks. Here are some of the most popular ones and how to use them:

Earnings per share or EPS: EPS is often already calculated and available on many platforms. EPS is an indicator of profitability – the higher the EPS, the more profitable the company. However, this metric should be considered when compared against competitors or across a period of time (i.e., to see if it’s higher or lower than competitors or if it has been increasing or decreasing over time).
Dividend yield: This shows the amount of money paid to shareholders as dividends for owning a share of the stock. Mature companies often pay dividends; however, a high dividend yield is not always preferable as it may be the result of a lower stock price. Have a look at this dividends guide for more information.
P/E ratio: This ratio is used to determine the relative value of the shares. A high P/E ratio could indicate that the stock price is overvalued and vice-versa.
Target price: analysts estimate a target price for a stock based on thorough research. They look at various factors like news, new contracts, industry trends, taxes, and regulations. They update their target price as they learn more about the company’s situation.

What else can I take into account when selecting stocks for investment?

There are many other metrics you may want to consider before investing in a stock. Here are some others that you can use to refine your search:

Market capitalisation: It helps us identify if the company is large or small. It can be used for calculating many ratios as well.
EBITDA: This figure shows a company’s profit before interest, taxes, depreciation, and amortisation. It’s a way to gauge the company’s profitability without accounting for items like interest expenses or one-time events like acquisitions.
EBIT: Compared to EBITDA, it includes depreciation and amortisation.
Debt ratios: these are useful to assess how risky the company is – for instance, a company with high debt ratios could struggle to survive during recessions (i.e. because interest rates often increase during recessions, the company must pay more to finance its debt).
Cash flow per share: This metric shows the financial strength of the firm. The higher the cash flow per share, the more money per share the company makes. Some investors consider cash flow per share more relevant than EPS. This is because EPS can be altered, while cash flow per share is more difficult to manipulate, hence it is considered more reliable.

All these indicators should be compared to the companies in the sector as well as with the historical data to see if the evolution is positive.

Additionally, other aspects must be taken into account when investing:

Diversify your portfolio: Don’t put all your money into a single company; instead, invest in a few different companies that show strong profitability.
Thoroughly research the company: Consider the company’s history, industry, and other economic factors that might affect its performance.
Risk analysis: Stock prices can be volatile, so look at ways to manage that risk.

Read more about stocks

Summary

Overall, when investing in stocks in the long term, you need to do your due diligence to pick the best ones according to your strategy.

Alternatively, if you want to trade stocks or invest in them in the short term, you may want to have a look at this trading guide instead, and then become familiar with technical analysis.

FAQs

How does market timing affect stock selection?

Market timing refers to buying or selling stocks based on short-term predictions of market movements. While it’s tempting to try and “time the market,” most financial experts advise against it. Consistent market timing is extremely difficult, even for professionals. Instead, consider a long-term investment approach focused on the fundamentals of the companies you’re interested in.

What role does industry analysis play in stock selection?

Industry analysis helps you understand the bigger picture surrounding a company. Knowing the trends, challenges, and opportunities in a specific industry can help you assess how well a company is likely to perform in the future. For example, investing in a tech company without understanding the competitive landscape or technological trends could be risky.

How does a company’s management team affect its stock value?

A strong management team can significantly influence a company’s performance and, subsequently, its stock value. Experienced leadership can navigate challenges effectively and capitalise on opportunities, leading to business growth. It’s often advisable to research the management team’s track record, including their past performance, experience, and qualifications, before making an investment decision.