Whether you’re a market beginner or an long-time trader, learning how to pick stocks is a lifetime endeavor. If you’re a beginner, you should start with a diversified portfolio. But once the work of assembling your portfolio is done and you’ve spent a lot of time learning and researching the market, you might be ready to start choosing individual stocks.
Wondering how to pick the best stocks? To choose stocks to invest in, you should:
- do your homework,
- look for trends in earnings growth,
- understand the volatility,
- look at the debt-equity ratio,
- look at the price-earnings ratio,
- look at a company’s management,
- learn about value investing, and
- don’t forget that practice makes perfect.
Check out our guide to how to choose stocks to invest in, and start making money on trading stocks today.
What Are Stocks?
If you want to learn how to choose good stocks, first, you need to understand exactly what stocks are. Stock is a type of equity that gives investors a share of ownership in a company.
Stocks are a way for everyday people to invest in some of the most successful companies in the world. For companies, issuing stocks is a way to fund the growth of their business. The money that companies raise by issuing stocks can fund new operations or product lines, for example.
There are two main ways that owners of stock are able to earn a return on their investment. First, if the stock’s price appreciates, or goes up, you can sell the stock for a profit. Second, some stocks pay dividends, or payments made to shareholders that come out of the company’s revenue. Dividends are usually paid quarterly.
The most common type of stock is common stock. Common stock usually pays dividends, and it also gives investors voting rights.
Companies usually start to issue stocks through an IPO, or initial public offering. Once a company sells its stock on the markets, those shares can be freely bought and sold by investors. Typically, then, when you buy or sell shares you are interacting with other investors, rather than buying from the company itself.
Once a company’s stocks are available on the market, trades are handled through a stock exchange. At a stock exchange, investors are represented by a broker, who handles the actual trades. These days, many investors use online stockbrokers, which connects them through a broker’s platform to the exchanges online. For this reason, in order to buy and sell stocks, you’ll need to open a brokerage account.
Follow these steps to learn how to pick the best stocks to invest in.
1. Do Your Homework
When you’re figuring out how to select good stocks for investment, it’s critical to do your homework. Research the company that you’d like to invest in. Start by doing a quick online search and checking out any recent news items about the company. This is a quick-and-dirty research method to let you know whether it’s even worth doing more research into the company.
Once you’ve done some basic research and have determined that a company is interesting, there’s much more you can learn about whether the company is likely to be successful.
2. Look for Trends in Earnings Growth
Look at the company’s earnings growth over time, and see if you can discern any trends. If a company’s earnings tend to improve over time, that’s typically a good sign that the company is doing something right. Even incremental change over time is a good indicator — a company doesn’t necessarily need to see rapid growth in order to be a good choice.
3. Understand the Volatility
The stock market is inherently volatile. This means that it’s normal to see a lot of year-to-year and even day-to-day change. A company’s value might fluctuate, and it could even occasionally lose value. But long-term stability is what’s really important in the markets.
When you’re choosing stocks to buy, focus on understanding the volatility of the markets rather than day-to-day gains or losses. Companies that perform well over time and weather downturns in the markets successfully are worth taking a second look at.
The only time volatility is your friend is when you’re trading penny stocks. Penny stocks, or micro-cap stocks, are initially traded for low prices. When you’re trading penny stocks, you want to take advantage of volatility by buying stocks that are rapidly spiking in price.
4. Look at the Debt-Equity Ratio
Even the biggest, most successful companies carry some debt. But debt is still an important tool to understand a company’s fundamentals.
The key figure here is a company’s debt-to-equity ratio (also known as D/E), or the company’s total liabilities on the balance sheet divided by the total amount of shareholder equity. Generally speaking, the larger this number is, the higher a company’s debt levels relative to their equity. Companies with higher debt-equity ratios are a riskier bet.
For investors with lower risk tolerance, look for a debt-equity ratio of 0.3 or lower. In general, debt-equity ratios can vary widely by industry, so check out the industry norms for a given company to assess whether its debt-equity ratio is high or not.
5. Look at the Price-Earnings Ratio
Like the debt-equity ratio, the price-earnings ratio, also called P/E ratio, is another stat that you’ve probably heard investors and analysts talk about when they’re assessing the underlying value of a company.
The price-earnings ratio measures a stock’s price compared to the company’s overall earnings. To calculate the P/E ratio, simply divide the current share price by earnings per share.
Generally speaking, the higher the P/E ratio, the higher you might expect that the stock’s price will grow in the future. The P/E ratio is useful for comparing companies across similar sectors or industries.
6. Look at a Company’s Management
Getting to know something about the company’s management can tell you something about its fundamentals that other metrics can’t. Leadership helps set the pace for the rest of the company.
A company that is managed well is more likely to be innovative and adaptive, and to have a stable company culture. Good management makes a company more likely to be able to weather downturns, and less likely to experience scandal that could tank the stock price or even put the company out of business.
7. Learn About Value Investing
Once you can assess these underlying metrics and measures of how well a company’s stock is likely to do, you can start thinking about your overall investment strategy. There are any number of different investment approaches you can take, and your choice will depend on your strengths as well as your level of risk acceptance.
One strategy we often recommend is called value investing. Pioneered by famous investor Warren Buffet’s mentor Benjamin Graham, value investing is focused on assessing a company’s intrinsic value rather than trying to predict sudden climbs and downturns in the market. The idea is to identify companies that have sound fundamentals, good management, and a likelihood of future growth over the long term that are under-valued at their current stock price.
You can use metrics like the P/E and D/E ratio, as well as the other research methods we’ve covered here, to pick stocks according to a value investing strategy. Value investing requires doing a good amount of research on the market and companies you’re interested in investing in, but it can yield great rewards in the long-run. Value investing is one of the best ways to pick stocks for beginners and investors who are risk-averse.
8. Don’t Forget that Practice Makes Perfect
Before you start investing a lot of your own money, hone your investment strategy through practice. Test out different investment strategies and research methods before investing your own cash.
You can create an account on a site that allows you to practice making trades without investing actual money. Some stock market simulator sites will give you a set amount of fake cash to work with. This can help you to get used to trading and understand how your trading decisions pan out before you start working with serious cash. It also gives you some of the excitement of making successful trades without risking a penny from your own wallet.
You can also create an account on a trading website like TD Ameritrade or TradeKing. Make sure to read over the platform’s user reviews and do your research to make sure that the website is a reputable one. Practice navigating the web platform and using it to make trades.
Looking to learn more about how to choose stocks? Our RagingBull team is made up of professional trainers who are traders themselves who actively trade options, ETFs, penny stocks, biotech stocks, and more every day. Our trainers help both new and experienced traders learn more about how the stock market works, how to get started trading, and how to choose the right stocks to start making money on the market.
To learn more about how to make money trading, check out our free eBook on options trading strategies. You can also read testimonials from some of our clients to see how we’re helping people just like you to become better traders.