The steps
Here's an easy, 9-step guide to learn how to pick a stock to buy.
There is a very important condition for investing successfully in the stock market. You need to know how to pick the right stock. It isn’t enough to follow the footsteps of other investors or just rely on things analysts and others say. Begin with your own research.
01
start with what you know
As a beginner, it is best to buy what you know. Start with a company or industry that's familiar to you because you know why you choose to buy your favorite brands, or how busy the chain restaurant down the street is on a typical night. That's not all the information you'll need, of course, but it may help you put those companies' earnings reports in context. You also understand the business model of the company - and how it plans to make money.
02
Begin your research
Once you list a few companies, begin your research. Successful investors often look for stocks that are "cheap" or "undervalued." Generally, what they mean is that investors are paying a relatively low price for each dollar the company earns. This is measured by the stock's price-to-earnings or P/E ratio. (Find that measure on marketwatch.com, or calculate it yourself by dividing a company's share price by its net income.) Very roughly speaking, a P/E below about 15 is considered cheap, and a P/E above 20 is considered expensive.
03
Evaluate the financials
Next, move on to evaluate the company’s financial health by examining its financial reports. All public companies must release quarterly and annual reports. Check the Investor Relations section of their web site. Don't just focus on the most recent report: What you're really looking for is a consistent history of profitability and financial health, not simply one good quarter.
04
Things to look out for
Focus on things such as revenue growth. Just a glance at the graph may give you a good image of the company’s performance. Anything can happen day to day, but in the long run, stock prices increase when companies are making more money, which usually starts with growing revenue. You'll hear analysts refer to revenue as the "top line."
05
The Bottom Line
Check the bottom line (expenses), too. The difference between revenue and expenses is a company's profit margin. A company that's growing revenue while controlling costs will also have expanding margins.
06
The balance sheet
Know how much debt the company has. Check the company's balance sheet. Generally speaking, the share price of a company with more debt is likely to be more volatile because more of the company's income has to go to interest and debt payments. Compare a company to its peers to see if it's borrowing an unusual amount of money for its industry and size.
07
Find a Dividend
A dividend, or a cash payout to stock investors, isn't just a source of regular income; it's a sign of a company in good financial health. If a company pays a dividend, look at the history of their payments. Are they increasing dividends or not?
08
Almost there!
If your stock has made it through these filters, reason out why exactly you should buy a stock. Be sure to avoid the common traps listed below!
09
Know when to sell
Remember you eventually do need to sell the stock. Have a set of criteria that will tell you it's time to sell: If the company cuts its dividend; if the price rises or falls to a certain point; if an analyst downgrades the stock, and so on. Having a plan for selling will help you avoid selling out of panic over a short-term move in the market. A plan for selling can also help you take your gains. Evaluate your portfolio periodically.
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The P/E ratio
While evaluating the P/E ratio, keep certain things in mind. A company that's expected to grow rapidly will be more expensive than an established company that's growing more slowly. Compare a company's P/E to other companies in the same industry to see if it's cheaper or more expensive than its peers. Also remember, cheap isn't always good, and expensive isn't always bad. Sometimes a stock is cheap because its business is growing less or actually slowing down. And sometimes a stock is expensive because it's widely expected to grow its earnings rapidly in the next few years. You want to buy stocks that you can reasonably expect will be worth more later, so look at value combined with expectations for future earnings.
The Traps!
Because it's cheap
Buying a stock which has recently dipped 10% but shows long term growth. Know exactly why the price has dipped, and whether the stock is expected to rebound.
Analyst recommendations
Analyst recommendations give you a list of stocks to focus on, not to necessarily buy. Again, it is an educated guess that stock will perform well, but remember that the prediction may be biased.
Short term fluctuations
Short term volatility shouldn’t surprise you; this is expected. Remember you’re purchasing the stock to hold it.
For more information: Nasdaq offers a 12-step process for evaluating stocks. Morningstar's Investing Classroom explains how to read financial statements. From the WSJ, here's more on when to sell and MarketWatch’s guide, Motley Fool’s guide and NerdWallet’s guide on how to pick a stock.