Owning a company’s stocks represents ownership in the business – be it customers, employees, assets, suppliers, etc. A stock is not just a ticker trading in markets and behind every stock, there is an actual business.
So when you want to find a good stock worth investing in, it actually means trying to find out a good business that is priced at a reasonable valuation.
A company’s stock can be evaluated in many ways. Here's more on how to choose a stock:
1) Buy What You Know
Choose an industry or a company that you are familiar with. You will never give money to a stranger unless you are sure that it will be returned. Right? The same principle applies to stock investing too. Just ask yourself – “Can I really understand this business?” For example - I know nothing of the pharmaceutical business as I’m not a doctor – so I will be better off buying stocks of companies in that sector.
2) Valuation
Investment professionals often look for stocks that are "cheap" or "undervalued." And the reason for a stock being undervalued is down to the fact that investors are paying a relatively low price for each rupee the company earns. This is measured by the stock's price-to-earnings ratio, or P/E. Very roughly speaking, a P/E below about 15 is considered cheap, and a P/E above 20 is considered expensive.
But there's more to it than just that:
Know what kind of stock you're talking about. A company that's expected to grow rapidly will be more expensive than an established company that's growing more slowly. Compare a company's P/E to other companies in the same industry to see if it's cheaper or more expensive than its peers.
Cheap isn't always good, and expensive isn't always bad. Sometimes a stock is cheap because its business is growing less or actually slowing down. And sometimes a company’s stock is expensive because it's widely expected to grow rapidly in terms of earnings in the next few years.
3) Financial Health
All public companies have to release quarterly and annual reports. Don't just focus on the most recent report. What you're really looking for is a consistent history of profitability and financial health, not just one good quarter.
Generally, stock prices increase when companies are making more money, which usually starts with growing revenue. So look for companies which have a history of consistently growing revenues.
The difference between revenue and expenses is a company's profit margin. A company that's growing revenue while controlling costs will also have expanding margins. A company earning higher margins is a much better investment than the one which earns lower margins.
Know how much debt the company has. Generally speaking, the share price of a company with more debt is likely to be more volatile because more of the company's income has to be directed towards servicing interest and debt payments.
4) Dividends
A dividend is a cash payout to stock investors. And it is not only a source of regular income, it's a sign of a company in good financial health. But remember that not every company pays a dividend. In fact, many fast-growing companies prefer to reinvest their cash rather than pay a dividend. Large, steadier companies are more likely to pay a dividend than are their smaller, more volatile counterparts.
When picking stocks, you should keep in mind that you are becoming part owner of the company. And keeping aside short term market movements, your investment will eventually depend on actual health of the business. So pick stocks of only those companies which are operating in simple, predictable, growing and high margin businesses.
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