Investing: How to Pick a Winning Company
As an investor, you always want to choose the winning company. With an average annual stock market return of 9.2%, you might think it’s easy to buy stocks and receive a positive return. Even with recent stock soars of GameStop and AMC that gained more than 400% and 278% respectively, caused by Reddit-users on the WallStreetBets forum, it is nonetheless important to look at the fundamentals of a company before buying into it.
These highly exceptional short squeezes are a heaven for those who invested before the rise, but picking a winning company is actually harder than it sounds and not every company will give you the sound return you wish for. Investing is about minimalizing the downside risk while being as objectively certain as you can of a stock price going upward.
You want to believe in the mission and vision of a company and at the same time seeing indicators that will give you confidence that this company will thrive.
To provide a helping hand in choosing a company to invest in, I want to share a few metrics in fundamental analysis that will help you gain insight in a company’s stock valuation, earnings, debts and ability to pay this off, efficiency in making profit, and dividend. And hence you picking the winning stock.
Investing is about minimalizing the downside risk while being as objectively certain as you can of a stock price going upward.
The price-to-earnings ratio is a metric that shows the market value of a stock compared to the company’s annual earnings. This is one of the key ratio’s that shows whether a stock is overvalued or undervalued.
A low P/E ratio indicates that the current stock price is relatively cheap to its earnings while a high P/E ratio translates to a stock price being expensive compared to the earnings of the company. It is useful for comparing companies within the same industry.
Noteworthy is that the P/E ratio doesn’t account for earnings growth which makes it a less useful metric for growth companies such as Tesla. The price/earnings-to-growth (PEG) ratio accounts for this factor by not only looking at the price of a stock compared to the earnings but by taking into consideration the annual earnings per share growth as well.
How much are investors willing to pay for a company’s assets? This question is answered by the price-to-book ratio where the net value of a company is compared to its market capitalization by dividing a company’s stock price by its assets.
A P/B ratio of 1 means investors are willing to pay 1 dollar for each dollar the company has in value whereas a P/B ratio of 0.5 translates to investors willing to pay half of the company’s net worth. This metric shows the market perception of a company and helps determine an undervalued stock.
D/E Ratio — Liquidity and Solvency
Solvency is the indicator to see whether the long-term debt load of a company is manageably seen from its net worth. The debt-to-equity ratio shows the company’s financial leverage, thus revealing how the company finances its operations through debt relative to its owned funds.
It is calculated by dividing a company’s total liabilities by its shareholder equity, where the latter is the result of assets minus liabilities. A higher level ratio means the company is using relatively more debt to operate, which is an increased risk indicator for investors.
The financial health of a company can be determined through liquidity and solvability where the former refers to a company’s ability to meet its short-term obligations. Does the company have enough cash or assets available that it can quickly turn into cash to pay off its liabilities in the coming year?
One way to measure the liquidity is through the current ratio which looks at current assets like cash, accounts receivables, and inventories. The other metric is the quick ratio that only looks at the most liquid assets, and therefore excluding inventories from its current assets. The higher the ratio, the better the financial health of the company.
The financial health of a company can be determined through liquidity and solvability … Does the company have enough cash or assets available that it can quickly turn into cash to pay off its liabilities in the coming year?
Free Cash Flow
How much cash is a company generating through its operations minus the cost of expenditures (e.g. rent, payroll, taxes)? The free cash flow can be helpful to check whether a company has sufficient cash left to use after funding its operations and expenditures.
The more free cash flow a company has, the more resources a company has to provide dividends, pay debts, buy back shares or pursue investments. Increasing free cash flows is an indicator that earnings may increase in the future.
Return on equity measures how efficient a company is at generating profits with the total amount of money invested in the company. This is calculated by dividing a company’s earnings by its shareholder’s equity. A company that can make more money with less investment is operating more efficiently.
Dividend Yield and Payout Ratio
In case you find it important to receive periodic dividends, the dividend yield shows how much dividends you will receive annually relative to its stock price. If you are looking for a steady dividend income, then it is sensible to pay attention to the payout ratio as this displays how much a company is paying out in dividends relative to its earnings and hence, how well the company is able to afford to pay its current dividend.
A high dividend yield and low payout ratio mean the company is paying out much dividend compared to its stock price, but they can afford it as their earnings are high enough. That is a sign of long-term dividend sustainability.
Before buying a stock, you should understand the concept of short float, that is the percentage of shares in the market that are shorted compared to all outstanding shares. The short float represents the conviction of short-sellers who believe the stock price will drop e.g. due to discomforting underlying fundamentals.
If a stock has a particular high short float, then it is especially sensible to conduct serious research into that company while considering buying its stock.
… you want to know who is in charge, what their track records are, and whether you see them fit to lead the company. It is the company you consider to entrust your money with after all.
Last but not least: do you trust the management to continue to build and grow the company? Of course, you want to know who is in charge, what their track records are, and whether you see them fit to lead the company. It is the company you consider to entrust your money with after all. You want to make sure your money is in good hands.
There are many metrics available to take into consideration while seeking investment opportunities, and these are the metrics that I pay most attention to while choosing the companies that I invest in. It is imperative to use several metrics to evaluate and compare potential investments in similar industries as a single metric provides limited insight.
There is always a risk in investing and as it is impossible to be absolutely certain that a stock will provide a positive return. Therefore it is highly recommended to conduct your research before buying into a stock to minimize negative surprises.
The aforementioned metrics are handy tools which you can use to assess, evaluate and compare companies to base your decision whether a company is worth investing in and aligns with your investment strategy.