The ultimate guide to picking stocks for beginners. A full breakdown of how to pick stocks when you’re starting out & 3 key steps to follow.
Picking out the right stock to buy, as a beginning investor, can be like trying to pick out the perfect movie to watch on Netflix. There are so many choices and most of them, you’ve never heard of before — and if you make the wrong choice, well, that’ll just pretty much ruin your Friday night.
Selecting the right stock to invest in, can be tough, but with the right plan and methodology — it’s doesn’t have to be.
How to Pick Stocks for Beginners
In this beginner’s guide to stock selection, I’ll break down my thought process and methodology on how I pick the right stocks for my investment strategy — through the 3 criteria I used to evaluate them. And this article is not just all concepts, I’m actually going to walk you guys through, tactically, each step in the process — with a real live stock example.
But before we get started, let’s just level-set the conversation. I’m talking about long term investing and selecting the right corporate stocks. For swing trading or day trading and evaluating other equities like mutual funds or ETFs, there are a lot of other considerations to take into account — so we’ll save those topics for a future article. Also, if you haven’t already read my beginner’s guide to the stock market where I outline the fundamentals of trading in the stock exchanges — make sure you check that out here.
So, now that we are level-set, for the sake of this exercise, let’s say that I want to dive into the technology sector — and I’m considering buying some Microsoft stock.
CRITERION 1: FUNDAMENTAL ANALYSIS
The first of my 3 criteria, when evaluating a stock, is to look at the company’s fundamentals.
Fundamental analysis is the method of assessing a stock’s inherent value by looking at all of the company’s business characteristics, which includes both tangible aspects like revenue, EBIT (earnings before interest & tax), assets on hand, etc, as well as intangible traits like the company’s brand equity or the distinctiveness of their technology, or the effectiveness of their c-suite, etc.
Honestly, there are so many things you could look at here — and if you try to evaluate every metric or aspect of the company’s business, you’ll be sure to get analysis paralysis.
So instead, I generally choose to focus on the following 3 fundamental factors:
1) Earnings Performance
Every publicly-traded company reports earnings on a quarterly basis. And for those of you that are not familiar with this term, earnings is just a fancy way of saying net income, or in other words, the margin after all of the operating expenses of doing business and all of the taxes have been taken away — simply put, it’s the profit that remains within the business after all expenses.
The timing of these earnings releases is based on each individual company’s fiscal calendar, so they vary from company to company — but they do all report 4 times a year. Now, the purpose of the earnings reports is to provide the shareholders with a review of the company performance for the past quarter. These reports include updates on the company’s revenue, profits, how they track against financial projections, what new initiatives or programs they’ve undertaken, and what their forward-looking guidance looks like for the upcoming quarters. As publicly traded companies, they have an obligation to us, the shareholders, to be transparent and open about their performance so that we as traders can make the most informed decision when it comes to considering their stock for purchase — and that’s one of the reasons they have these quarterly reports.
One thing that is of key importance within this report is the company’s EPS — or earnings per share.
The EPS is the amount of profit that a company has earned in the last quarter, divided by the number of outstanding shares in the stock market — so basically, how much profit does the company have for each share of stock that’s out in the open market. Each company reports this out in their quarterly earnings statement and it is a good proxy for how profitable a company is.
Now before every quarterly earnings statement, financial analysts will predict what they think the EPS of a stock will be — and at every earnings release, a comparative analysis is done to determine whether or not the company beat, met or missed analyst EPS projections for that quarter. As such an important profitability metric, when a company beats EPS expectations, they are seen as having done a really good job and the market sentiment turns positive and the stock generally spikes up that day… but when a company misses, the opposite feeling occurs and the stock price generally falls for a short period of time.
(This isn’t 100% true for every stock and every situation, but again, generally speaking, this is the trend most stocks follow.)
Now let me walk you guys through how I use this data in my stock selection process. I start by looking up the historical performance of the company’s EPS vs analyst projections. If you’re using a full-service brokerage firm like Etrade, you simply navigate towards the earnings section and scroll down to the bar chart to see this info.
What I look for is a consistent track record of EPS releases that have beaten analyst expectations — it doesn’t have to be green every single quarter, but if it shows a steady record of more greens than red — that’s a good sign.
In the case of this example, it looks like Microsoft has beaten expectations for the last 11 quarters — that’s amazing. Here is another example: Amazon.
It’s not all green, but there are steady periods of exceeding analyst expectations — and that’s what you want to see. Past performance is not a 100% accurate indication of future performance, but if they have a good history of beating earnings projections, then you can feel more confident about making that same bet for the future quarters as well.
2) Company Profitability
Profitability is the second thing I look into when it comes to fundamental analysis. Now, when it comes to profitability, the first thing I typically look at is the net profit margin line of the company.
This percentage indicates how much net profit they have — that they can use to invest in the growth or innovation or any other new aspects of their company. This net profit margin line is also calculated after the distribution of any dividends — which means it’s the left-over profit, even after paying the shareholders a dividend. So the higher this number is, the more pure profit they have.
In the case of Microsoft — 31% is incredibly high, there are only a handful of Fortune 500 companies that operate at a higher rate of profitability than this one. It gives me the confidence to invest in companies that have high-profit margins because I know that these companies are the ones that are the best poise for innovation and transformation within their organizations, as times change because they have the financial means to do so.
Another factor in profitability that I look at, is the PE Ratio. This is a common one that most investors start with when they are looking to measure up a stock. It stands for Price to Earnings Ratio — and it’s calculated by taking the current stock price and dividing that by the EPS that we talked about earlier. Basically — what this shows is, compared to the amount of profit that a company has made per share of outstanding stock, how much more is the price of this stock?
In the case of Microsoft, their most recent EPS is $5.40. Microsoft stock, as of 4/8/2020 is trading around $165 per share. That means that this stock is trading for around 30 times more than the EPS — or in other words, 30 times more than the amount of profit the company has made per share of stock. This is also why analysts sometimes refers to this as the company’s earnings multiple.
So, why is this important? By distilling the profitability of a company down to the EPS and dividing the share price to that figure, we can get to a somewhat common and impartial value upon which we can measure how expensive a stock is compared to the profit that it brings. It’s a way to make as close to an apples-to-apples comparison of how overvalued or undervalued a stock price is, between 2 companies.
For example, we know that Microsoft has a PE ratio of 30. If we look at another stock like Apple Inc, it looks like their most recent PE ratio is 21. So an analyst might say that in this case — if we only look at the PE ratio in isolation and consider no other factors in our stock selection process, then Apple Inc would be a “less expensive” but because you are only paying 21 times the amount of profit they make for each share of the stock.
Do you guys follow me here? If this sounds a little confusing and you’ll like to watch me walk through the explanation visually, click here.
3) Business Model and Growth Potential
The third and last factor I look at, when it comes to company fundamentals — is the business model and growth potential of the company. Now, this part of the analysis is more art than science but essentially, I want to make sure I understand, at a high level, what the business units of the company are and how the P&L operates — and compare that to how other companies operate and decide which business I feel has better growth potential in the near future. As a long term investor, it’s important that you know at least the basics of how your company operates in terms of the products and services it provides, how it generates income, and what plans they have to drive innovation and progression in their industry.
How I acquire this information is I usually go to that particular company’s website and look for the investor relations section. Within this section, there are usually key press releases that highlight new and noteworthy pieces of information about the company, as well as recordings of their latest quarterly release press conference and the annual report that comprehensively summarizes the yearly performance of the business as a whole. And I generally try to read as much of all of this as possible. Here is a look at what the most recent annual report looks like for Microsoft.
If you look at this report — it does a great job of outlining Microsoft’s projections of where the technology industry is headed, Microsoft’s current charter to align to the trajectory of the industry, past financial performance and an overview of the different business units and how they’ve contributed to the overall success of the company as a whole. There is a lot to glean from all of this information — and to be honest, if you’re interested in technology as a subject, it can actually be a pretty fun read as well.
Absorbing all of this information helps you understand how solid their brand is, how strong their strategic planning is and whether or not the leadership team has the right mindset to carry the company forward into the future — all key things to evaluate when deciding to invest in a stock.
That wraps up Fundamental Analysis — which was the first of my 3 criteria.
CRITERION 2: ANALYST RESEARCH
The second major step in my evaluation of stocks is studying financial analyst research.
There are hundreds of thousands of professionals out there — whose primary job is to analyze macro/micro-economic conditions and market trends to provide large banks and investment firms with recommendations on what sectors, industries or companies they need to invest in. And as part of this work, they evaluate the stocks of individual companies and provide something called an outlook or a price target — which is a prediction of which stocks to buy and what price they’ll hit in the next 12 months. Normally, you’d have to pay for research like that — but some brokerage firms will provide this to you, for free, as part of their standard service. Etrade happens to be one of those firms — so let me show you how to read this information and what I look for when I’m looking into these analyst’s projections.
So here is the aggregated analyst research page for Microsoft.
The first thing you’ll notice right off the bat is the price chart of the analyst targets. As you can see, out of the 27 financial analysts that have provided 12-month outlooks, the highest price projection is $212, the low projection is $160, which this stock has already met, and the average price that these analysts think Microsoft stock will get to, within the next 12 months, is $192. Now you should always take these analyst recommendations with a grain of salt, as they are usually only right about 60–70% of the time — but still good insights to know.
Below the chart, it actually shows the 27 analysts and more detail regarding their ratings (including articles that expand upon their stock buy ratings & prices) so you can see what factors led them to their particular price targets.
And below that, there are also other independent research firms that publish stock ratings and actions — which you can read to get even more depth on whether or not your stock would make a good long term investment at this point in time.
It’s important to gather as much perspective as you can so you can be aware of the broad spectrum of opinions on a particular stock — and therefore make the most informed choice in your selection process.
CRITERION 3: PERSONAL INTUITION
Now, the last check that I perform before deciding on a stock to purchase — is to check my personal intuition.
-Do I know and trust the brand of the company?
-Do I enjoy the products or services this company provides?
-Do I believe this company’s offerings will be needed in the future and be pivotal to the ever-changing landscape of the consumer or commercial marketplace?
These are the questions that I ask myself to make sure I have a good gut feeling about this company. At the end of the day — you have to have a good feeling about what you are about to invest in. I know you are supposed to take the emotions out of trading, but we are not robots AND part of the fun and joy and excitement of buying a stake of ownership in a company, is knowing that you like what this company does and that you take pride in the ownership of this stock. It’s not the most quantitative or empirical step within my stock selection methodology — but for me, it’s actually a pretty important factor.
Now that pretty much sums up, at a high level, the outline of my stock selection process. but whenever I speak to people about this topic — without fail, there is always a question about technical analysis.
What about reading charts and indicators and things like that, Daniel?
Well, usually when I make a swing trades, I definitely make the technical analysis an important part of my research. I look at things like the moving averages, Bollinger bands, RSI and chart candles, etc — but for long term investing, these technical indicators aren’t as useful, especially when you’re looking at a 5–10 year time horizon.
Technical analysis is important in trying to focus on the exact buy point and sell point to maximize the spread between your entry and exit margin — but for long term investing, it’s not as critical to be so precise. Sometimes I buy low, sometimes I buy high — but if I’ve really done my research, picked the right company and I’m planning to hold long term — I’m confident that I’ll see a very nice return regardless of what my entry point was.
So — I hope this gives you a good basis on how to conduct fundamental stock analysis for your investment strategy.
As with all things, picking the right stock investment can be a bit of a time consuming effort, but the more you learn about the company you are buying into, the more confident you’ll feel about owning their stock and the more excited you’ll be about having them be part of your overall investment portfolio!
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**** Disclaimer *****
The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.