We get many questions daily from our users, “How do you pick a good/best stock?” For that first, we need to start with some basics. Let’s take a look at five ‘approaches’ to consider when first examining a best stock. These are common investment styles, and they all work, but they also need to be highly personal based on your own psychological makeup.
These are some Strategy used to pick the best stock
Price to Earnings
This is often the first thing investors will look at. It simply shows what a company is trading at in relation to its per-share earnings. Some investors will not buy a stock if this ratio is above a certain level, say 15 times. The problem here: earnings can be manipulated, and can include all sorts of write-downs and/or special charges. A stock with a P/E of 5 times might be ‘cheap’ until you find out there were one-time earnings gains not likely to be repeated. A stock at 35 times earnings might look ‘expensive’ until you find out it took a large write-down which hurt earnings in one particular year. Our advice? Look at P/E ratios for sure, but also look at the numbers.
Price to Cash Flow
We would consider this an all-around better metric than earnings, for multiple reasons. First, cash flow cannot be manipulated like earnings can be. Second, for dividend investors, cash flow determines whether a company can continue to pay its dividend. Cash flow is also important for companies looking to do acquisitions or buybacks. We would suggest looking at cash flow first, and earnings second. Because of certain accounting methodology, cash flow metrics make comparisons between companies easier as well.
Momentum investors look for positive change. They want to see companies beating earnings estimates, with corresponding price movement and increases in trading volume. We love watching momentum. Companies beating earnings, with rising stock prices and rising volume, really get our hearts racing. If you overlay this with new highs on the stock, even better. The problem with momentum investing? A reversal. High momentum stocks tend to be very expensive, and when momentum fades stocks can get hit very, very hard. It is though, usually a good ride for a while. We suggest watching momentum trends for sure, even if just for new stock ideas.
Price to Book
Value investors love this metric. They look at accounting value, or book value, and compare this to the current price of a stock. On occasion, they can buy a stock for far less than what its ‘true’ value is. It is a decent financial metric, for sure, but there are drawbacks. The biggest problem is determining whether book value is ‘real’. Energy and mining companies, for example, are falling all over themselves taking giant write-downs on assets. This, of course, lowers book value. It is a good ratio to always consider, though, and investors such as Warren Buffett consider it key.
We could fill this whole paper with lessons on picking stocks through technical analysis. The thesis here is that investors do not even need to care about what a company does, or what sort of announcements it makes, nor what its valuation, cash flow, or debt are. The secret is in reading the charts and interpreting volumes. Technical analysts look at ‘breakouts’ where prices move above certain moving averages. Buy signals can be based on volume or hundreds of other indicators. We use technical indicators, but only after we have looked at fundamentals. As confirmation of an investment thesis, they can be very useful. But deciding if a stock is a buy or sell by only looking at a chart still seems a little strange to us.