10 Factors to Consider When Selecting a Stock
Quick Checklist: 10 Rules of Thumb for Selecting a Stock
These rules of thumb are explained more fully in a section below.
- The 52 Week Range: Make sure the stock is trading closer to the 52 week low than the high and also has upward momentum.
- Volume: Average volume should be around 50,000.
- Price/Earnings Ratio: The PE ratio should be somewhere between 1.0x and 10.0x.
- EPS and CPS: Earnings and cash flow per share should both be positive with positive growth over each quarter.
- Market Cap: There is no specific market cap to look for, just be aware of the risk/reward trade off of each size and their stability as well. (Personally, all of my highest returns have come from mid caps.)
- Beta (Volatility): Beta is much like the market cap, in that there is no specific beta to look for. It just depends on risk tolerance. However, if you have a longer time horizon to invest, I would recommend a higher beta and vice versa.
- Dividends: Look for stocks that offer dividends. Dividends are usually, but not always, a sign of good financial health.
- Open Interest on Options Chains: Look at the open interest on options chains for a specific stock to see how many people are planning on buying and selling and at what price. This basically serves as an opinion poll on the stock’s expected performance.
- Insider Activity: Always consider the amount of shares CEOs and other executives are buying and selling, to get an accurate picture of what is happening on the inside.
- News: It may be a good idea to avoid stocks that are constantly in the news. Stock prices will often reflect the investors’ recent perception of the stock, which is usually not an accurate evaluation of the underlying, long-term value of the company. The dot-com bubble of the '90s is a perfect example.
1. The 52-Week Range
Typically a stock is considered a good value if it is trading near its 52 week low. However, make sure the stock is on a rebound if it is near the low, because it could always drop farther and create a new low. Don’t get caught in the assumption that a stock can’t possibly go any lower. A stock can always go in either direction, no matter how much the price has fallen. On the other hand, if a stock is trading near its 52 week high, it should probably be avoided because it will likely hit a resistance level and shoot downward.
Volume is the number of stocks bought and sold in a single day of trading. Make sure the average volume of the stock is over 50,000 or so. If the volume is low, then liquidity is low. This means it is hard to buy and sell because there aren’t many buyers and sellers and the stock moves in a very choppy fashion. This creates a lot of unnecessary volatility, which most traders generally avoid. This is the unfortunate scenario often involved with trading penny stocks.
3. Price/Earnings Ratio (P/E)
The PE ratio is a critical number in evaluating stocks. The formula for finding the PE ratio is a simple one:
Price per Share / Earnings per Share
So if the price of the stock is $2 and the EPS is $1, then the PE would be stated as 2.0x. It is unnecessary to remember this formula since the PE ratio is always listed on the “quote page” of a stock. The reason for the formula is to show you the relationship between the numbers and give you an idea of how to tell if a stock is over or undervalued.
Think of "undervalued" as "underpriced," and "overvalued" as "overpriced." If the PE is very high, then the price per share of the stock must be much more than its earnings per share, which means the stock is overvalued, or overpriced. The opposite is true if the PE is low. So basically, it is beneficial to look for companies with low PE ratios between the range of 1.0x and 10.0x. When the market is performing better, the preferable range would be increased to around 10.0x and 20.0x. If the company has negative earnings per share, then the PE will not be listed.
EPS (Earnings per share)
4. Earnings per Share (EPS) and Cash Flow per Share (CPS)
What is EPS? Earnings per share is determined by the above formula:
(Net Income – Dividends on Preferred Stock) / Average Number of Shares Outstanding
EPS breaks down the profit or earnings of a company in terms of individual shares. Investors should look for positive earnings as well as consecutive growth over each quarter. If a company fails to meet the earnings expectations of analysts, it instantly decreases the stock price when the actual earnings are announced.
EPS has one near-fatal flaw: a company’s accounting department can easily manipulate it. Nevertheless, it should still carry some weight in choosing a stock.
A similar measure that has grown increasingly popular is cash flow per share or CPS. Accounting may be able to hinder earnings to look more favorable, but cash is impossible to manipulate. CPS gives a true account of how much cash a company really has on hand, and how effective its operations are. This is a crucial statistic in itself to determine if there is enough cash to pay off debt and engage in future endeavors that contribute to stock price increases. Look for a company that has both positive EPS and CPS.
5. Market Cap
Market cap is determined by the following formula:
Number of Shares Outstanding x Price per Share
Remember that owning a stock is actually a partial ownership in the company. If someone were to buy the entire company, they would have to buy all of the stock. The market cap could be thought of as the overall price to buy out a company. The market cap is used to classify the size of the company into one of the following categories: nano, micro, small, mid, large, and mega caps. The large and mega caps are worth billions of dollars, while the micro and small caps my only be worth several million dollars. Basically, the larger the company is, usually the more stable and safe it is. There are exceptions such as GM and Enron, of course. Think of the sizes and the stability of stocks as trees. The nano cap could be compared to a small maple tree that is violently blown around in storms (market crashes) and could be easily uprooted (bankruptcy). The large caps are like mighty oaks that can withstand many violent storms with little damage. However, the small maple tree can grow several feet over a few years, while the large oak has matured and fosters little potential for extreme growth. Basically, when investing, look at the market cap or size classification to find something that matches your risk tolerance. The smaller the company the more potential growth, and the more possible risk. The opposite is true of large companies.
6. Beta (Volatility)
Beta is an indicator of a stock’s standard deviation, or volatility. It is somewhat difficult to calculate, but is provided on many websites. The calculation involves taking the standard deviations of the monthly returns of the particular stock along with the S&P 500’s monthly returns for five years within the same time horizon and inserting the two standard deviations separately into an overall variance formula and dividing by the population variance.
Using beta is much less complicated than calculating it. If a stock has beta of 1.0 it moves in congruence with the market. This means if the S&P 500 goes up 1% in a day, the stock should go up 1% in a day. The opposite is true if the market goes down. If the beta is 2.0, and the market increases by 3%, then typically the stock will go up 6%. Sounds great until the market drops 3% and the stock falls 6%. If the beta is negative then it moves inversely, or opposite of the market. Very few stocks have negative betas.
Typically, large blue chip companies will have the lowest betas. Microsoft is normally around a 0.9 or 1.0, moving with the market. Pfizer is usually a 0.8 beta; meaning if the market goes up 1% it will only increase 0.8%. Casinos usually have the highest betas. The Las Vegas Sands is currently a 4.7. Beta is really a double-edged sword. Theoretically, an investor could make the quickest, and most significant gains with a high beta stock, but could lose the most as well if the market underperformed. If you like to watch your money move like crazy from day to day, I would recommend a high beta. If you like to play it safe and preserve your money, I would recommend searching for a low beta that has little volatility.
Dividends are cash paid per share by companies to reward their shareholders for holding their stock. They are comparable to coupons on bonds, except they are not as high. When investing in a company, check to see if they are currently paying a dividend. If a company has money to hand out, then they are usually doing well. The companies that pay the highest dividends often have steady growth.
8. Open Interest in Option Chains
Many stocks offer options contracts for buying and selling in the future. An investor doesn’t have to understand options to take advantage of this tip. When researching a stock on a financial website, there is typically a link for options chains. These are simply the options available for the stock.
They are often listed in “T” shaped boxes with call options (the right to buy the stock) on the left and put options (the right to sell the stock) on the right. The strike prices are listed down the center of the “T”. These prices give a range in which the stock is expected to move. Both the call and put sides have open interest columns; this is the key. The people in the open interest column on the left are bullish; they think the stock price is going up. The people in the column on the right are bearish; they think the price is going down. There is a different amount of open interest for each expected price.
Look for stocks that have more open interest on the call side than the put side. This shows that more people want to buy the stock in the future than sell it. It is worth getting a second opinion, or in this case, thousands of opinions when purchasing a stock.
9. Insider Activity
Take note of what is happening inside of the company itself. If the CEO just dumped 50,000 shares, it may be time to get out. The insiders know the company better than any analyst. If the number of shares bought by individuals inside the company has been increasing, it may be a good time to buy.
News affects the expectations and decisions of the investing public and expectations determine stock prices. Popular glamour stocks such as Yahoo or Apple are always in the news, and the prices are sometimes inflated by the hype of the press. Try to choose stocks that are not the victim of newspaper publicity and television headlines, and there’ll be much smoother sailing.
Which of the following best describes your current knowledge of investing?
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.