Josh Callaghan, Canstar’s General Manager of Wealth
You’ve decided to break away from the crowd and try your hand at picking individual stocks. It’s not for everyone, but if there was one piece of advice I could give it’s this: know why you’re investing in that company!
There’s a myriad of ways to pick stocks and determine the value of a company. Most tactics can generally be grouped into two main buckets, fundamental analysis and technical analysis. Rather than getting caught up in the semantics, let’s just say that fundamental analysis is making a buy or sell decision based on the fundamentals of the business. Whereas, technical analysis is making that decision on the basis of market factors to predict price movements.
We’re just going to discuss fundamental analysis as that’s likely what most of our readers will be interested in.
How do you determine the value of a company?
Valuing companies is a little bit science and a little bit art. It’s why some people are great at picking stocks and others are… well… less great. The basic premise though is that by considering a company’s existing assets and liabilities, estimating future cash flow and factoring in a prediction of growth, an investor can come to a value per share for that stock. From there an investor can determine whether the market has over or undervalued that stock.
Many investors use ratios such as PE or PEG to help in their estimation. For more information on ratios check out this article.
But beyond the maths, investors also need to be clear about what they like about a company and where the future growth potential is coming from. It’s essentially creating a narrative for the company that you can quantify in the numbers and assess against their future announcements.
Say we were investing in ABC & Co, our narrative might sound a little like this:
I really like ABC & Co at the moment as they have strong balance sheet (meaning solid cash reserves and low debt). Also, for the past four quarters they’ve had a consistent run of profit that is putting cash in the bank and they seem to be close to cracking a distribution deal in Europe. This deal will see their product sales double over the next three years. They’re a very scalable business which means that those product sales won’t materially increase the cost of supporting the European operations. Therefore, the profit margin should improve even further. All other factors look solid.
Combined with favourable valuations, this sort of narrative tells us a few important things. Cash and profit are two key factors in choosing this stock. Therefore, if either of these were to change in the future, we would need to reconsider our position. Also, our assessment of the future growth potential of the stock is linked to the European distribution deal. This gives us a focus to what we are listening for at investor updates and reading in annual reports. If this deal falls over we’ll need to revaluate our position.
Doing the hard work can help give you peace mind
This is important because stock prices can move around a lot and it’s not always to do with the fundamentals of the business. Market forces, environmental factors, political factors and the like can all move a stock price. If you’re not sure why you’re invested in a stock or what factors make that stock valuable, then how are you going to evaluate whether you should sell or buy more when the price moves?
From personal experience, it’s much more comfortable holding a stock that’s gone down 20% when you understand the fundamentals of why you’re invested in the company. Conversely, when you get swept up in the excitement of a stock without doing the hard work, a fall of 20% can be a lot less comfortable. Generally, once that stock starts to tank you realise that you actually know very little about it and have nothing to reassure you that you’re not on your way to zero.
When you’ve outsmarted the market, stock picking can be really rewarding both financially and emotionally. Investors who are looking to pick individual stocks need to be prepared for the ups and downs that come with that. The best way to be prepared is to know why you’re investing in that company by doing the mathematical analysis and creating a narrative.