Here are outlines some strategies to help you pick a good stock
Picking the right stock at the right time, and booking profits, is a challenge for many small investors. With hardly any time for research and a desire to reap quick profits, many investors often rely on friends and expert advice. The risks are considerable even if you chase a rising stock, without comprehending the driving forces. How do you differentiate an overheated stock from one that has truly appreciated in its intrinsic value?
Identifying an under-valued stock
An under-valued stock is a great investment pick as it has high intrinsic value. Currently under-valued, it has immense potential to rise higher and make the investor richer.
A low price-to-earnings (P/E) ratio can be an indicator of an under-valued stock. The P/E is calculated by dividing the share price by the company's earnings per share (EPS). EPS is calculated by dividing a company's net revenues by the outstanding shares. A higher P/E ratio means that investors are paying more for each unit of net income. So, the stock is more expensive and risky compared to one with a lower P/E ratio.
Trading volume is an indicator
Trading volumes can help pick stocks quoted at prices below their true value. In case the trading volume for a stock is low, it can be inferred that it has not caught the attention of many investors. It has a long way to ascend before it touches its true value.
A higher trading volume indicates the market is already aware and interested in the stock and hence it is priced close to its true value.
Debt-to-equity ratio
A company with high debt-to-equity ratio can indicate forthcoming financial hardships. If the ratio is greater than one, it indicates that assets are mainly financed with debt. If the ratio is less than one, it is a scenario where equity provides majority of the financing. Watch out for stocks that have low debt-to-equity ratio.
Some other pointers
Historical data of stocks that have performed consistently and yielded good returns are reliable.
A higher profit margin indicates a more profitable company that has better control over its costs compared to its contenders in the same sector.
Weeding out over-heated stocks
Avoiding over-priced stocks that could plunge anytime is as critical as picking the right stocks. Buying over-heated stocks and losing money in a bubble burst is not an uncommon phenomenon in the markets. Stocks that have moved up the ladder very quickly are potentially risky. The sudden spurt could be based on a rumour or event not backed by strong fundamentals.
Good market conditions or bull runs do not last forever. Investors, who believe that good times are here to stay often burn their fingers. On a similar note, an over-valued stock has little scope or space for upward movement and could lose its momentum anytime.
A little bit of research and analysis will help investors make prudent investment choices even in bear market conditions.
