What to Know When Picking a Stock
A new generation of investors has been born amid the pandemic. A recent survey by Charles Schwab found that 15% of people who own stock started trading in 2020, but picking a good investment is not as easy as it may seem.
Broadly speaking, there are two schools of thought as to what makes a good stock: value stocks and growth stocks. Value stocks are stocks that are cheap because investors are too pessimistic about them. Maybe they’re not in a sexy industry; maybe they’ve had a recent run of bad luck. One example in the current market environment is packaged food companies. These companies are not very sexy. They did well during the pandemic as people ate at home more, but investors don’t trust that to last.
Then there are growth stocks. These stocks are more expensive, but hopefully for a reason, maybe their business has been growing especially fast or is expected to in the future. The trick here is to avoid overpay and getting growth at a reasonable price. Right now, technology stocks, as is often the case, are an example of growth stocks that are a bit expensive in the market.
Then there are what I would call highly-speculative stocks, which are so expensive that you really need an ideal scenario to play out for their valuation to make sense. So you can make money on these, but only if everything goes perfectly. Right now, that includes a lot of the so-called meme stocks popular on Reddit, and certain hot sectors like electric cars.
So how to tell if a stock is expensive or cheap? There are a lot of different metrics, but the most common one is the price-to-earnings ratio. The price-earnings ratio is quite simply the price of a stock divided by its earnings per share. A higher ratio means a stock is more expensive; a lower ratio means a stock is cheaper. The price-earnings ratio can be measured against earnings over the past year or expected earnings in the future.
If we look at earnings over the past year, the average ratio for the last 10 years is around 18. So a good rule of thumb is that if a stock is more expensive than 18 times earnings, it’d better be a growth stock; it’d better have a lot of growth to justify that price. If it’s under 18 times earnings, it could be a value stock; it could be cheap.
So when you have an idea of a company you might wanna invest in, the first thing to do is to look at valuation. What’s the price-earnings ratio? Is it higher than average? Is it higher than it has been recently? Then look at the fundamentals. How fast has this company grown its profit or earnings over the last few years? Then you can decide, is this a growth stock, is it a value stock?
You can make money in both kinds of stocks, but there are pitfalls to watch out for. So in a value company, ask yourself some questions like: why is the stock cheap? Are those reasons gonna get better anytime soon? And how long can you afford to wait? For a growth stock, you should be asking, what could cause growth to slow down for this company? What could go wrong? Perhaps a competitor come in. For one of the highly-speculative stocks, you should ask yourself, how likely is this Goldilocks scenario really? And how willing are you to lose most or all of your investment if it doesn’t come to pass?