Stock Markets: How to Choose the Right Stock

Investing in the stock markets is exciting as well as riddled with a bit of tough exercise when it comes to choosing a stock for a company. Undertaking proper research and not getting carried away by behavioural biases can go a long way in creating wealth in this regard.

Here are a few steps that an investor can undertake before taking the plunge in the stock market.

Focus on financial goals: Before zeroing in on any investment option it is crucial to first establish the financial goals. Once this is set, the rest of the things tend to fall in place. For example, a younger investor would be more focused on increasing their investment portfolio in the long run, while an older investor would be concerned about building a suitable retirement corpus.

Understand the risk appetite: There are various investment tools available in the market, which tend to differ in their returns and risks as well. Therefore, it is important for an investor to analyse their personal preference when it comes to taking a risk. As per needs and requirements, an investor should consider opting for a suitable investment instrument.

Gain insight about a company before investing in a stock: Making an informed decision after gaining a thorough understanding of a particular company can go a long way. Ensure that adequate research is undertaken with due diligence before investing. Ideally, do not be carried away by the herd mentality in the market, which could lead to a loss of money.

Take into account the financial ratios: A particular business entity’s financial disclosures generally include a profit-and-loss statement, balance sheet, and cash-flow statement. Taking these documents into consideration, an investor would be able to track the historical growth, profitability and efficiency of the management, etc. Some of the ratios which are taken into consideration include the working capital ratio, the quick ratio, earnings per share (EPS), price-to-earnings (P/E), the debt-to-equity ratio, and the return on equity (ROE). In order to make an informed decision, an investor should compare these ratios over the years and between counterparts of a similar stock market sector or industry.

Be mindful of value traps: This is a typical scenario where a company is not truly undervalued, however, it is experiencing financial distress and a lack of future growth prospects. Ideally, an investor must consider qualitative factors such as a company’s management effectiveness, competitive advantage, and potential catalysts to remain mindful of value traps.

Avoid running behind high yields: Dividend investors typically tend to go in for stocks with high dividend yields. However, this method could lead to holdings of unprofitable, stagnant companies. The calculation of dividend yields involves dividing annual dividends by share prices. Therefore, when a particular stock’s price begins to dip, a downward yield can appear high on a momentary basis.

Ideally, payout ratios need to be calculated by dividing the dividend payout rate by earnings. In case it is more than 100%, then the company is not suitably profitable to pay its dividends based on retained earnings.

Choose a company’s stock as per competitive advantage: A company with a sustainable competitive advantage is more likely to maintain its hold and position in the market. An investor can adopt a qualitative approach, which involves taking into account the size of a company, that is economies of scale, intangibles, which includes patents, licences, brand recognition, etc, and cost, that is cost leadership and switching costs, which help to analyse the competitive advantage