Building Your Wealth: Investing in Stocks Part II – Evaluating Potential Stocks

Evaluating Potential Stocks

One of the biggest challenges investors can face is coming up with possible stocks to invest in.

A slogan I have heard is the five-stock principle: for every five stocks you analyze properly and purchase, three will do about what you predict, one will do far worse, and one will do far better. I don’t know if this is actually true, but I do know that you have to be prepared that you’ll select a few stinkers, even with your best efforts at analysis.

There are two main ways you can analyze potential investments – fundamental analysis which determines what you buy, and technical analysis which can show you when to buy.

But first, if you’re thinking about a scheme that relies exclusively on someone’s opinion, promises to help you get rich quick, or promotes a “foolproof” system that “guarantees” you high returns with little effort you are wasting your time – and most likely your money.

These include:

  • The hot tip from a guy at work or someone you sat next to on the plane.
  • Media recommendations which are most often meant for entertainment and to sell advertising space.
  • Buying what you know. Well-known fund manager and author Peter Lynch advocated this method, but just because you like a particular brand or industry doesn’t necessarily mean the companies are well run or the industry is stable.

Evaluating Potential Stocks

Companies and their stock fall into industry categories such as consumer staples, energy, financials, health care, industrial, real estate, telecommunications, and utilities. Each company’s risk level, line of business, management team and finances are different from the next.

As an investor, it’s critical that you buy shares only in companies that fit your investment personality and needs. Because no stock comes with a guaranteed rate of return, you’ll want to do your best to assess whether your stock pick will give you the performance you’re hoping for.

Fundamental analysis

Fundamental analysis evaluates the nature and quality of a business, so you can reach a decision about the current worth and future potential. It is based on the facts about a company as well as how it’s doing in the industry and general economy.

To narrow down the huge list of available investments use a stock screener as a starting point. You input certain predefined criteria based on your investing strategy. For example, you might want to look at utility companies or dividend growth yield between 4 – 8%. Make sure your criteria are not too broad or you’ll get too many results. Screening can also introduce you to companies you’re not familiar with.

Then you can analyze such things as profitability, earnings, sales trends, debt, and other factors and compare them to other similar companies (sector, size and line of business) to get a better picture of what the company is all about.

Calculating ratios such as earnings-per-share (EPS), price-to-earnings (P/E), and price-to-book value gives investors valuable information and provides an easy way to compare stocks of different companies.

Examine past performance of the company as well as their vision for future direction.

Technical analysis

Technical analysis uses charts to track the prices, trading frequency, sales volume and any external factors that are believed to influence share price. The idea is that if you follow certain indicators, you can predict the best entry point to buy the stock.

However, this is a form of market timing and may not be a good indicator of future performance. At the very least, use it in conjunction with fundamental analysis.

Where to get information

You used to have to wade through a company’s quarterly and annual reports to get this information, but now there are many sources available on the internet for stock data.

Find stock screening tools at Stingy Investor, and Stock Rover. Sites such as Morningstar and Globe Investor will give you stock screens, price history, a run down of what the company does, who its competitors are, the latest news, and all kinds of statistics and financial information. They even have the ratios calculated for you, so you don’t have to do the math yourself.

Related: TD Direct Investing WebBroker Platform Review

Don’t overlook the excellent resources at most online brokerages. Click on Market Research/Tools for stock screens, company information and charts. For a summary, read what the analysts have to say.

Obviously, each of the analysts reporting for different resources has their own method for evaluating a stock. You still need to use your own judgement – analysts can be wrong.

Final thoughts

Buying individual stocks can be a risky business indeed, but it can have its rewards. It all depends on how much time and energy you are willing to put into research.

You should do what you can to get as much information as possible, while using your judgement and personal experience to reach independent conclusions.

Next up, we’ll see how to identify winning companies.

Print Friendly, PDF & Email

1 Comment

  1. EngPhys on December 7, 2017 at 12:52 pm

    Both fundamental and technical analysis have long been proven ineffective. Fama and French won a Nobel Prize debunking fundamental analysis with the efficient market hypothesis. Vangaurd recently released a study showing people lose a lot more money trying to time the market than making money. A Random Walk Down Wall Street by Burton Malkiel has long shown the follies of both fundamental and technical analysis.

    Individual investors playing these games are going up against all the big mutual fund managers who do this for a living. These types of games are much more gambling than investing.

    For effective investing, buy well diversified, low cost funds and rebalance annually.

Leave a Comment

Join More Than 10,000 Subscribers!

Sign up now and get our free e-Book- Financial Management by the Decade - plus new financial tips and money stories delivered to your inbox every week.