Top 5 Ways to Pick a Good Stock
With so many statistics and stock tips floating around, how are you supposed to separate the wheat from the chaff?
Whether you’re using the Financial Times, Yahoo Finance, or you’re one of the lucky ones with a Bloomberg Terminal, it’s likely you’ve encountered a bad case of statistics overload. With increased accessibility to company data and ever improving computing power, there are hundreds of indicators which people claim to wield the crystal ball of Wall Street. Here’s our Top 10 statistics and indicators to keep in mind when you’re evaluating a pick or running a stock screener.
1. Price-to-Earnings Ratio (P/E Ratio)
Probably the most common valuation statistics, this works by comparing the the price per share to the earnings per share of the company in question. Trailing P/E uses past earnings per share data, while Forward P/E uses future forecast earnings per share data. Trailing P/E is generally more reliable as it derives from past results, but Forward P/E might be more useful to you, given past results are no guarantee of the future. A high P/E ratio means that investors have priced in significant optimism, with the price being far out of proportion with historical earnings data. A low P/E ratio is a little more difficult to interpret, sometimes it means there’s pessimism, sometimes it just signifies stability. An average P/E ratio for a stable stock is around 25. Anything between 20 and 30 can generally be considered as fairly valued at the current market price.
2. Recommendation Trends
This is the specific title they are given on Yahoo Finance, my platform of choice, but really this refers to analyst suggestions. This is often overlooked by similar guides, as people like to think they are better than the big analysts. While you shouldn’t use analyst recommendations as the key factor in your decision, they’re worth paying attention to, as typically there’s a good reason if the recommendations are overwhelmingly in one direction. Always remember to check the dates that analyst made these recommendations though, as typically it can be a long time between re-evaluations of a company whether it’s an upgrade or a downgrade.
3. Credit Rating
The feasibility of an investment heavily relies on a companies ability to service its debt. There’s no better way of getting a good appraisal of this ability than finding a credit rating for the company. This will obviously be easier the bigger the company, but if you’re lucky enough to have access to more extensive databases you may be able to make this a key part of you evaluation methodology. Credit rating can be a superior way of judging a company’s financial health than just looking at the balance sheet, as credit rating agencies have extremely detailed information and forecasts on industry growth. That’s not to say they are always right, Standard & Poor’s maintained Lehman Brothers’ “A” grade credit rating until only six days before their collapse in 2008.
4. Price/Earnings-to-Growth Ratio (PEG Ratio)
Possibly my favourite valuation tool, the PEG ratio is strongly related to the P/E ratio we looked at before, dividing the P/E ratio of a stock by the growth rate of the company’s earnings over a given time period. I personally prefer this to the P/E ratio as there is a much more consistent range in which you can tell you’ve found a good pick. A company that is fairly valued by the market should have a PEG ratio of exactly 1. Anything between 0 and 1 signifies a stock is undervalued, and anything above 1 suggests it is overvalued.
5. Short % of Shares
A little different to the others, this metric is about gauging the market consensus rather than specific fundamental analysis. The higher the percentage of shares that have been shorted, the more pessimism there is in the future of the company, as traders are willing to put their money on their line to bet on a downward movement for the company. It should be noted that you don’t need an extremely high short % to ring alarm bells. With shorting representing a much greater risk for traders than a long buy position, a growing number of short positions even in the single digits should encourage you to seek out news you may have missed that could be driving pessimistic sentiment on the company.
Most investors and traders alike would be lying if they told you they’d never used a little intuition or a hunch to make a decision, at least on the small scale. But what most call a “hunch” is really your brain putting together all the information and giving you a nudge in the right direction. Even if you aren’t devising an extravagant stock screener or evaluating system, its worth looking up these five stats on any stock that catches your eye.
