A. Establish Your Goals
The first step in investing is to figure out what your portfolio’s goal is. The opportunities that a stock market provides are open to all investors. However, it is the thoughtful investor that knows precisely how he plans to utilise those opportunities to meet his specific goals. Before reaching the stage of stock selection, you must first determine what short-term and long-term goals you are hoping to finance with your stock market earnings.
Is it for the purpose of saving for your retirement? Is it going to help you raise capital to launch a business? Defining goals such as these will help you narrow down your strategy
B. Find Companies You Understand
When you buy a stock, you become a partial owner of a business. If you don’t understand the business, you’re setting yourself up for failure.
The more familiar you are with a company, and the better you understand its business and competitive environment, the better your chances of finding a good “story” that will actually come true.
You can find companies anywhere. You use dozens of products and services every day, so take a moment to consider the companies behind them.
Also consider companies that may impact you indirectly. Many businesses don’t ever deal directly with consumers. When you go to check out at the supermarket, who makes those machines that take your payment? When you buy your medicine at the pharmacy, who’s actually making those drugs? What equipment are they using? When you get your car fixed by a mechanic, where do they buy new parts and who makes those spare parts? When the signal on your phone drops because there’s not a cell tower in sight, who’s really responsible for building new towers and who makes the equipment that goes on those towers?
C. Determine A Reasonable Stock Price
One can start looking at stock pricing after cutting down the list of equities you’re examining to companies with a significant competitive edge. There are numerous methods for determining whether or not a stock’s current price represents excellent value.
1) Price-to-earnings ratio (PE ratio): The PE ratio divides a company’s stock price by its earnings per share over the previous year. When a stock’s PE ratio falls below its historical average, investors can discover it trading at a fair price. Well-established enterprises with consistent earnings and growth are the greatest candidates for this indicator.
2) Price-to-Sales Ratio (PSR): The PSR is more useful for growth businesses that aren’t profitable or have very volatile earnings. Again, past averages can be a helpful guide, but keep in mind that future expectations must be taken into account. It’s important to remember that not all sales are made equal. A corporation may launch a new product or service with a significantly lower profit margin than its primary business, but which accounts for the majority of its revenue increase. As a result, investors’ expectations about how the stock should trade in relation to future sales must be adjusted.
3) Discounted cash flow modelling: If you really want to delve into the weeds, look at a company’s financials and start forecasting sales growth, profit margin, and other expenses for the next few years. Then, using those revenue and operating expense forecasts, create a model for future earnings. You can estimate the stock’s worth by discounting those cash flows by your needed rate of return. You’ll get a respectable stock price if you divide that by the number of shares outstanding.
4) Dividend yield: If you’re looking for a way to make money, dividend yield is an important metric to think about. If a stock’s dividend yield is higher than normal, it may be trading at a decent price. Make sure you don’t fall into a yield trap, though. Dividends might be unsustainable at times, so analyse the payout ratio as a percentage of earnings and free cash flow to see how safe the dividend is. Also, keep an eye on the future to ensure that the earnings and cash flow are stable and rising. By estimating dividend growth over the next many years, you can even create your own dividend discount model.
D. Purchase A Stock With A Safety Margin
The final phase in stock selection is to purchase firms that are trading at a discount to your estimate at a reasonable price. This is your safety margin. In other words, if your valuation is off, you’ll save a lot of
money by buying considerably below market value. You might not need a large margin of safety for a stock with stable profits and a positive outlook. You’ll probably be alright if you take 10% off your desired price. You may desire a larger margin of safety for growth stocks with less predictable earnings. Aim for 15% to 30%, depending on your level of confidence in your estimation. That way, if things don’t go as planned, you’re covered.
E. Keep An Open Mind
Keeping up with market news and opinions is critical. Passive research includes reading financial news and keeping up with industry blogs written by writers whose perspectives you find interesting. A common-sense observation can serve as the fundamental argument. After you’ve been acquainted with and convinced of the overall argument as a result of this type of qualitative study, you may go on to business press releases and investor presentation reports for more in-depth examination. You may end up with a single investment prospect or a list of ten or more companies at the end of your investigation. And you can invest in any of these, depending on your preferred industry.