What to Look For When Selecting a Stock

Equity research in a nutshell

Image credit: Finshots
Image: Freepik

The Foundation

The first step is determining whether you prefer a top-down approach or a bottom-up approach. The top-down investing approach involves looking first at the macroeconomic picture of the country in which one is investing in and then trickling down on to the smaller factors in finer detail.

The Key Parameters

1. The reputation of the Management Team and Board of Directors

Before you dive deeper into the quantitative aspect, ensuring management quality and transparency is crucial to long-term investment success. If the people running the organization aren’t accountable to its shareholders then sooner or later this phenomenon will be reflected in the company financials and their stock price.

2. The Financials and Business Model

Financial metrics and how the business makes money are the first two quantitative elements to look at. On rare occasions, I have discarded a few stocks just after this step. My logic to do so depends on the three criteria listed below.

  • Absurd Valuation- If the P/E and P/B ratios are unbelievably high, it could signal that either the stock is overvalued or that the markets themselves are overvalued and all the corresponding stocks are riding on the same rally.

The only exception to this rule is technology stocks since it’s extremely difficult to forecast their earnings and correlate their growth with any ratio whatsoever.

A perfect example can be Amazon, which has had P/E ratios of above 40 for months now, but despite that, the company continues to soar in the stock market. Ratios are not a one-size-fits-all kind of parameter, so they should be used with thorough judgment.

  • Economies of Scale- if the unit economics do not scale chances of a company continuing to be a profitable decline in the long run. The exception to this rule again is technology stocks. Stocks that redefined the gig-economy for example Uber, Airbnb are prime examples of this phenomenon.
  • Unreliable Book of Accounts- When analyzing financial statements, each line item must make sense to you as an investor. If more than three or four line items do not add up or make perfect sense for their allocations, try reading the footnotes. If the management is trying to hide any piece of information the approach taken in the footnotes will clearly help you decipher such anomalies.

3. Competitive Advantage

  • The network effect: Mainly a focus on identifying potential software apps that could become a billion-dollar unicorn, a network effect is when every incremental user makes the experience better for every other one. A strong network effect of creators and users draws in additional users at lower costs and dries up the competition faster as the years progress.
  • Brand: One of the toughest ones to decipher as an investor and build as a company, but one that can lead to phenomenal returns. Brands give companies a unique “moat”.
  • Tackling Industry Competitors- Whether the company is part of a growing target segment or whether it is doing business in a highly competitive and dying industry will be critical as you progress throughout the years. Holding the stock of a company that has declining profit margins due to increasing competition and declining market demand can sometimes be the “sell” signal one needs to completely exit a stock.

4. Analysing trends

The two key trends you should focus on are:

5. Calculating the Intrinsic Value

A prima-facie conclusion for the above steps all lead to a calculation called “DCF”. Discounted Cash Flow (DCF) involves discounting the future stream of cash flows one expects from holding the stock and finally discounting it’s terminal value in addition to the other cash flows to arrive at a number that may or may not accurately depict the stock’s “fair value”.

The Role of Technical Analysis

Technical analysts usually base their buy/sell recommendations on the charts and other mathematical indicators they see on their screens. The indicators are ideally nothing more than a depiction of market sentiment.

Concluding remarks

The stock markets are a Ponzi Scheme to some even till this day. They would rather gamble their money away in a Las Vegas casino rather than invest in a “blue-chip” company that will continue to grow and expand in value, entitling its shareholder to massive capital gains or dividend paycheques.

Most of the problems when it comes to investing are centered around human psychology.

The very same psychology gives rise to market inefficiencies which in turn makes this whole process of researching a stock a meaningful and (hopefully) profitable experience.

Image: Freepik

--

--

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store