New investors are often interested in choosing new stocks but are often overwhelmed by the sheer volume of different stocks out there to choose from. There are, after all, a wide range of different stocks and industries that you can choose from. Finding the right stocks can be difficult but can be made easier by understanding certain trends regarding stocks and doing some financial statement analysis on the stocks you are choosing between.
For many people, looking into financial statements can be a real challenge and there are many websites that accumulate ratios and other relevant data in a more digestible form. Here are certain factors that you should look into when choosing between different stocks.
1) Price to Earnings Ratio: A price to earnings (P/E) ratio will tell you how many times earnings a specific stock is trading for. This will show you, that if the company does not increase their earnings, how many years will it take for the stock to earn back the amount that you pay for it. While this can be a useful figure in a mature industry that is not changing significantly, it can be a bit distorted in newly developing industries that are growing significantly and when a company still has a loss. On an overall basis, it is commonly thought that a P/E ratio of above 15 is historically expensive while below 15 is relatively cheap.
2) Free Cash Flow: A free cash flow figure is on a company’s cash flow statement and basically shows the cash flow from operations plus and capital investments. The importance of a free cash flow figure is the cost that is required to sustain a business each year and the figure will show how much money is available to make investments by a company as well as the amount that is available for further investment or expansion, stock buybacks, or debt repayment. In other words, how much money is available for a company’s management to invest in other things or to give money back to shareholders.
3) Debt to Equity Ratio: A debt to equity ratio will show how much debt financing a company has in comparison to an equity investment by shareholders. Here, neither figure is particularly good or bad but needs to be taken into context with other factors. A high debt to equity ratio may show that a company is in deep debt and unable to sustain itself, or may show that they are taking into account low interest rates and using this cash flow to repay shareholders by buying back stock. If a company has a particularly high or low debt to equity ratio, you should learn what led to this as well as the prospects of the company in order to learn about whether it is a good idea to invest.
4) Net Income: Net income shows how profitable a business is in a given period. While this is an important figure to track in a stock, particularly over time, it can be distorted seasonally or in other contexts, and often needs to be taken in as part of a large context.
Despite all the aforementioned information, different industries have different factors that are important. Net income may be an important factor in most industries but it provides a distorted view in certain industries such as telephone utilities and real estate companies which may have a significant amount of depreciation that is not reflective of profitability and success.
Ultimately, individual care and learning the industries of the companies that you are investing in is the best way to first learn about, and then invest in, a new stock.