How to Pick Stocks – Step-by-Step Guide to Choose Stocks

Stock markets have a plethora of options to choose from, and every company has a distinct market valuation. Therefore, selecting the right stock can take time and effort for a beginner investing in stock market trading. To find success in the stock markets, one has to put some effort into researching the company’s profile and its industry.

Choosing the highest-valued stock may not always turn profitable, as they are also susceptible to market risks. Therefore, it is crucial to understand what parameters to look for while investing in the stock market. 

The section below covers a step-by-step guide to picking the right stocks  

Step 1: Determine the Investment Goal 

Every investor has a unique financial objective for investing in stock markets. The investment objective makes it easier for individuals to calculate the risks and allocate their earnings accordingly. Furthermore, having a goal also helps determine the investment tenor, as per an investor’s age and financial stability.

These stock market investments have three major objectives, namely:

• Growth Centric

Investors willing to earn high-income look for emerging companies with considerable growth prospects for the future. To do so, they determine the market demand for the service or product offered by the company. 

Emerging companies have high growth potential, so they are often preferred for long-term investments. Furthermore, younger companies are often undervalued as they are relatively unknown to the markets, allowing investors to diversify their portfolios by investing in multiple corporations.   

Note: Investing in younger companies also invites capital loss if the company underperforms or decides to liquidate.

• Dividend Generation

A dividend is an amount that a company may decide to pay its shareholders out of its own profits based on the number of stocks owned by the investor. Stock with high dividend yield provides stable income to investors. Therefore, these stocks suit investors who want to hold high-quality stocks for an extra income source.

Note: Investors need to ensure that the companies they invest in have a past history of providing stable dividend income and the company has healthy growth plans in future also to sustain and enhance the profitability.

• Capital Preservation

Investors close to retirement or willing to live off their savings often prioritise capital preservation. For capital preservation goals, investors do not aim for high returns; they aim for security. 

Therefore, investors not willing to participate in high-risk/high-return stocks opt for defensive stocks. These are known to not lose their value as much as regular stocks in volatile markets. 

Note: For capital preservation goals, companies with consistent demand are suitable investments. Companies in sectors like food and FMCG (fast-moving consumer goods) have perennial demand. 

Step 2: Have in-depth Knowledge of the Company and Its Industry.

Any change in a company’s fundamentals has an impact on its share price. Therefore, it is of utmost importance to have a sound knowledge of the industry and its workflow. This not only gives investors an idea of proposed policies but also helps to make decisions to sell or buy more stocks as per market trends.  

It is always advised to only invest in corporations if you completely understand how it generates funds.

Step 3: Analyse the Economic Moat or Competitive Advantage

In stock market parlance, an economic moat is the amount of competitive advantage that a company has in its sector. As competitors are one of the biggest threats to a company’s future growth potential, having a ‘wider moat’ allows the company to keep growing. 

Analysing the moat is a challenging task. Competitor advantage or moat establishes a corporate’s Unique Selling Point and how it stands out from the rest of the competitors. High-moat companies often earn significantly higher returns over time.

However, these investments are still subject to market risks, and long-term returns depend on the company’s effort to upscale its business. For example, mask sales were at an all-time high during the pandemic. However, the industry sank as soon as the nation was out of the pandemic.

High-moat stocks are usually limited to emerging companies. Therefore, investors must analyse the market trends and demands to sort out companies which have the potential to maintain their competitive edge for the long term.

Step 4: Check the Return and Growth Parameters  

Now that you have prepared a list of companies where you want to invest, let’s learn how you can understand their returns and growth parameters. The following are some of the financial ratios used for this purpose: 

• Price to Earning Ratio (PE Ratio)

PE ratio is the total share price of a company divided by its earnings per share in the past year. Therefore, a higher PE ratio justifies a stock being overvalued, whereas a lower PE ratio states that the stock is undervalued or appropriately valued. Consider investing in companies with moderately low PE ratios, as it may earn you good returns over time. 

However, these parameters are rough estimates of the past year and may change as per the market scenario.

• Debt to Equity Ratio (DE Ratio)

DE ratio measures the outstanding liabilities of a company compared to the earnings retained by it. Essentially, it assesses the debt paid back by a company to its lender compared to its total equity.

A high DE ratio indicates that a company is overburdened with debts. But with lesser debts, a company can concentrate on upscaling its business further by expanding the workforce, upgrading the warehouse, or boosting its authority by marketing. 

It is important to note that a company in a capital-intensive sector will typically have a higher DE ratio than companies in other industries.

Step 5: Choose what suits your requirement.

Now you have all the information required, you can start your stock investment journey. However, estimate your affordability or fair share prices before investing in stocks. You can easily decide on a reasonable share price by determining your financial status and how much you can or should invest in a particular industry per share.

Lastly, you can invest in growing companies with a relatively lower share price compared to their value. This will let you make considerable profits when the company grows into a market leader.

Final Words

The stock market can be an enticing platform to invest in. However, investors should not get emotional while picking stocks; instead, they should focus more on their objectives. It is not always true that a company offering shares at a very low price will be profitable; hence, it would be best if you trust your research.

Frequently Asked Questions