Definitive Guide to Stock Picking



There are several strategy about stock picking that you can search in the web. Chartist or Traders usually employ Technical Analysis of Daily Price movement while the Fundamentalist or Value Investor uses financial ratios and analyze business performance of the company in picking stocks.

Both these strategies have their strengths and weaknesses although the latter has more rationality. Stock investment is sound if its business-like as mentioned by Benjamin Graham and Warren Buffett. After all, stocks are pieces of a company which is built for business. 

Here are the important steps to choose a good stocks:

1.  Sort the companies according to profitability. 
Ratios like 5-year ROE (Return of Equity), OCF/Equity (Operating Cash Flow to Equity Ratio), and Net Profit Margin (Net Income/Revenue) are useful in assessing the profitability of a company. There are more ratios but  to keep it simple these 3 will do. In order to screen the stocks, all stocks can be listed with the 3 parameters then sort from the highest 5-year ROE  to the lowest.
All stocks with 5-yr ROE of less than 15 can be omitted. Then check the Net Profit Margin of the qualified stocks. The higher the NPM (say 20), the better. High net profit margin also indicates competitive strength of a company since it means that it has more room to give the customer a competitive price with less impact on its profit.

2. Check the growth potential.
Annual net income growth rate on the last 5 years should be checked to know if the management have done good in managing the company. Then research about the upcoming plans of the company  for growth like expansion, marketing programs, acquisitions and etc. For example, the sector with high potential in the Philippines is the energy sector due to low power plant installation and rapidly increasing power demand. Because of this companies like FPH, FGEN, EDC, AP, SCC and AC have been working overtime to put up new plants. These companies are expected to grow in the future. 

3. Analyse the Debt
Debt to Equity ratio is a good measurement of the company's leverage level. DE Ratio of 100 or less is considered a conservative level of debt. Exceptions are companies that are rapidly growing and thus will require more debt to fund its expansion. However, debt reduction plan should be defined by these companies. Current ratio (current assets/current liabilities) can be employed to check the liquidity of the company. A current ratio of 1.5 or higher means that the company can handle its debt obligation for the year. 



4. Estimate the Intrinsic Value
There's no exact science in estimating the value however it is important to know how to estimate the intrinsic value of a stock. This can be done by projecting the future cash flow of the company and computing the total present value of all the projected cash flow. 

5. Check the PE Ratio
PE Ratio or the Price to Equity Ratio is a quick way to find if a stocks is cheap although this must not be the sole parameter in choosing stocks. PE ratio of  less than 10 is considered oversold, 10-20 means fair value while higher than 20 means the price is expensive.  A caveat, some stocks that are growing fast may have PE ratio of 20 or higher but this doesn't mean that it is expensive while other companies with PE ratio of less than 10 might have a problem which makes it unattractive to investors. It is important to analyze the story behind the PE ratio to came up with a right judgement in using this. 

6. Buy stocks with Margin of Safety
Since it is difficult to establish the exact value of a stocks, it is important to buy it a discount by employing margin of safety. Suggested is buying the stocks at 60-70% of the assessed intrinsic value although the higher the margin, the better. 

One last piece of advise, aside from doing the mentioned steps, it is good to buy the stocks when the general market is down. This is a good step for as long as your investment horizon is long term. Doing this will give more return, once the market mood swings to the positive side again.

You might want to read : Prerequisites in Stocks Investing



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