Four Primary Stock Selection Criteria
Due to popular demand (i.e. one vote on a recent Facebook poll conducted by Apple Tree Wealth Management), I wanted to write a brief post about how to pick a stock to invest in.
Before I get too far into this post, though, I want to make it clear that while I will do my best to layout the basics of this process, there are thousands of different techniques for stock selection, and no one method is right and no one method is wrong.
This post is intended to be a starting point from which you can base your research on, but should by no means be the end all and be all of stock investing.
Okay, now that we have the disclaimers out of the way, let’s discuss the four main criteria I suggest you look at when picking a stock. I have chosen to focus on two qualitative, and two quantitative criteria.
- Understand your goals and risk tolerance
- Invest in what you know
Do you think you can follow all of them?
Even stock analyst limit their domain to a sector, such as healthcare, in which they may only cover 10 stocks at any given time.
We (you and I) are not stock analyst, and we do not spend our entire day researching and keeping up to date with stocks. It is not possible to do so.
What is the solution? Stick with what you already know.
If I asked you what Comcast did, what would you say? Probably that they operate cable networks.
What do you think about their services relative to Verizon, who recently released FIOS? What do your friends say? Are they changing service providers?
How about Zimmer Holdings? Do you know them?
They design and market orthopedic reconstructive devices. Have a lot of friends that recently had knee replacements? Ask them why they chose the Zimmer Holdings technology over that of Stryker Corporation and see what they say.
I don’t anticipate many of you having that conversation any time soon.
While I am not saying that investing in companies that you don’t know is a bad idea, I am saying that for those of us who have limited time and resources, sticking to what you know will allow you to make better investment decisions.
To clarify, PEG is not a fastener used to piece together IKEA furniture.
PEG is the Price/Earnings to Growth ratio.
To fully understand the PEG ratio, we first need to understand what the P/E ratio is.
Many have heard of the Price to Equity, or P/E ratio.
The P/E ratio is defined as the price of a stock divided by its earnings per share.
So if google has a stock price of $600, and earnings per share (EPS) of $30, it’s P/E ratio is 20.
Conventional wisdow suggest that the lower the P/E, the most attractive an investment is.
The reason for this is that a low P/E suggest that the price of a stock relative to its earnings is low.
Looking at the example above, let’s compare Google to Yahoo (real companies, fictional numbers). If Yahoo has a stock price of $600 and EPS of $15, it would have a P/E ratio of 40.
Which investment would be more attractive?
The answer would be Google, because their earnings, relative to their stock price, are much higher, suggesting that the stock will appreciate in the future.
However, a high P/E ratio does not necessarily suggest a stock is too expensive, and just because one companies P/E ratio is lower than another, does not make it the better investment.
Because the stock market projects the value of a company at some point in the future, not necessarily today, the growth prospects of a company play a factor in its price.
Enter the PEG ratio.
The PEG ratio, as explained earlier, is defined as the P/E ratio of a company relative to it’s growth.
In keeping with the example above, we determined that Google would be a more attractive investment option because it had a lower P/E ratio.
However, what if Yahoo was expected to grow its earnings by 25% next year, while Google was only expected to grow its earnings 10%.
The PEG ratios would be as follow:
- Google: P/E Ratio of 20 / 10% Growth = 2.0
Yahoo: P/E Ratio of 40 / 25% growth = 1.6
The lower PEG ratio of Yahoo suggests that its price, relative to its future growth prospects, is lower than that of Google, making it the more attractive investment option.
- Revenue and Earnings Growth
The final component to review is the revenue and earnings growth of a company.
Revenue is defined as sales. Pure and simple. If Apple sells 100 iPhones, and each iPhone costs $100, they have sales of $10,000.
Consistently growing revenue is a sign that a company is growing, that it’s products are in demand, and that they are keeping up with changes in its market environment.
Earnings are a measure of the profitability of a company.
Let’s look at the Apple example above:
- Apple has revenue of $10,000 (100 iPhones * $100 per phone)
However, each phone cost $30 to make. This means that apple has CGS (cost of goods sold) of $3,000.
Earnings = Revenue – Expenses.
Earnings per share = Earnings / # of shares outstanding.
While revenue is a good measure of a companies growth, earnings is a measure for profitability.
If Apple sells 100 iPhones for $100 each year for the next 5 years, its revenue will stay the same.
However, it the cost to make an iPhone drops $3 each year, Apple is becoming more profitable, a good sign that the company is using its assets well.
A consistent rate of growth for both revenue and EPS is indicative that a company has good management, a stable market, and a good business model.
This may seem obvious, but it is often overlooked when determining what stock to by.
When I say understand your goals, what I mean is you need to understand why are you investing in this stock.
Do you want to double your money in six months? Do you want the proceeds to buy a car next year? Or are you planning on making this investment to hold for the next 10 years and are just looking for slow, steady growth.
If you want to double your money in six months, you are going to have to invest in significantly riskier stocks than if you were looking to just match what the market does (Learn more about the risk-reward trade-off). If you want to buy and hold for a long period of time and want moderate growth, you may be inclined to choose a less risky investment.
A general rule of thumb is if you need the money sooner rather than later, you should choose less risky investments.
On the contrary, if you don’t need the money for quite some time, you can assume more risk.
But what is risk, and how can I measure it?
From an investment perspective, risk is generally defined as volatility, and is measured by an investment’s standard deviation.
In layman’s terms, the more wildly a stocks price moves up or down, the more risky it is.
The most common way to put this into practice is to look at a stocks beta.
Beta is a measure of the risk of a stock relative to a benchmark, typically the S&P 500.
- If a stock has a beta of 1.0, that means that for everyone 10% price move in the S&P 500, either up or down, that stock will tend to move 10% up or down.
If a stock has a beta of 2.0, that implies that for every 10% price move in the S&P 500, up or down, that stock will tend to move 20% up or down.
The higher the beta, the higher the inherent volatility of that investment.
You need to understand your goals, and the risk you are willing to take, before choosing which stock or stocks are most appropriate.
So again, while these four criteria are by no means exclusive, they should provide you with a good starting off point to make a stock (or stocks) investment.
If you have any questions, or would like anything else discussed in more detail, leave a comment below and I will reply as soon as possible!
Yahoo! Finance (free) – A great resource to find some of the statistical information discussed in this article, including Beta, EPS, PEG, and P/E ratios
Company Website (free) – In addition to general information about the company, their websites usually have links to the company annual report. The annual report has a number of great pieces of information, including financial statements, as well as discussions by management about their vision of the company, and the opportunities and challenges they face.
Morningstar.com (free & paid) – More qualitative and quantitative information about a company. Some free services, some paid.