Stock Selection: To Buy or Not to Buy?
A mini guide to choosing the right stock…
What to look for in a stock?
Picking the right stock does involve a mixture of technical and fundamental analysis. Overlooking one aspect of the stock selection process can be a costly mistake, affecting the value of your portfolio. It’s important to do your homework before selecting a stock, and not to buy something that looks “right.”
Company financials are one of the most important aspects during the stock selection process. The main purpose of your investment is to generate cash flow from dividends, and appreciation in the share price. Looking at the company financials can help analyze which direction the company is heading off too. Common Financial Indicators include but are not limited too…
- Overall growth in Earnings Per Share (EPS) from the last 5 quarters
- Consistent growth in book value/share from the last 5 quarters
- Change in profit/growth rate
- Debt to equity, operating margin, net profit margin, quick ratio & current ratio, return on capital
The ‘Big Picture’ must also be taken into consideration. Having an understanding of the industry would be a great tool to use during the stock selection process. For example, understanding that the oil industry was going through a surplus in supply would have saved yourself from being apart of the ‘oil crash,’ during Fall 2014. Financial indicators are another factor to look into, as some industries typically have higher debt to equity ratio than others. For example, the financial and insurance sector has a typical debt to equity average of 1.034 where as the food services, and drinking places have an average debt to equity ratio of 2.441 (Statistics Canada, 2009). Due to industry differences, it is best to compare companies with other companies in the same industry sector.
Have a look at the chart of the security, and develop a good technical understanding of it. Detecting patterns is an extremely useful tool to acquire to help determine when is the right time to purchase the stock.
- Last 10 years
- 6 months
- Volume vs. price
- EMA 200, 50, 13
As mentioned before, the main purpose of investing is typically to receive cash flow from dividends, and appreciation in capital, in order to make a gain upon sale. Value Investing involves determining whether the company’s financials are sustainable for long-term growth. A ‘value stock’ would typically have declining outstanding shares, thus sharing the profits among fewer shares each year, declining debt to equity, and increasing dividends.
Especially if you are not familiar with the company, doing prior research to the company is almost just as important as the looking at the financials. It is important to understand how the company generates cash flow from its operational activities. Looking into the company’s financial statement will typically provide details on the management objectives, and the website would also give some valuable information as well. Last but not least, looking into the suppliers can be a great strategy. Especially for growing companies – the suppliers can benefit from their increase in sales.
Examples, as of June 8th, 2015
– IBM, 3.05% YTD
- March 31st, 2015 quarterly financial results: -57.17% change in EPS
- March 31st, 2014 – March 31st, 2015: 2.6% EPS growth, 8.5% increase in cash flow from operating activities
– AAPL, 15.78% YTD
- March 31st, 2015 quarterly financial results: -24.03% change in EPS
- March 31st, 2014 – March 31st, 2015: 40.12% EPS Growth, 45.83% increase in cash flow from operating activities
Analysis: Both companies have negative EPS growth for the quarter ending March 31st, 2015, however Apple has significant growth from the last 5 quarters, and an increase in cash flow that is 5.39x higher than IBM. Strong EPS and sufficient cash flow from operating activities typically contributes to the stock performance.
When to get out?
You’ve purchased your share – now what? When do you sell your shares and cash out on the profits? The answer is different depending on your investment objectives. You may be investing for the short term, or long term. However, despite this, monitoring the stock performance will give you an indicator of when to sell your shares. Common indicators include weakening Earnings Per Share growth, declining cash flow from operating activities, and more volatile stock movements. A decline in earnings per share does not always indicate that the share has reached its peak. For example, AAPL’s (15.78% YTD) EPS has declined 24.03% during the quarter ending March 31st, 2015, however, the EPS has grown 40.11% from the quarter ending March 31st 2014 to March 31st, 2015. This shows that it is important to always look at the financial statement as a whole – not to focus on one time period and to rely on different indicators.
Writer: Jelani Smith
Disclaimer: All investing can potentially be risky. Investing or borrowing can lead into financial losses. All content on Bay Street Blog are solely for educational purposes. All other information are obtained from credible and authoritative references. Bay Street Blog is not responsible for any financial losses from the information provided. When investing or borrowing, always consult with an industry professional.