As a new stock investor, your toughest job is finding quality, inexpensive companies to buy. You want a stock that will likely go up in the future, and you don’t want to pay too much for it now.
There’s a quick way to begin, and it’s available at many brokerages: the stock screener. It’ll help you sort stocks by any criteria that you think are important, so you can focus on the most likely candidates for further research.
But finding candidates is just the start of the process, as investing in individual stocks requires a lot of work. You’ll need to:
Investigate the company and its management; research the industry; evaluate the financials, such as the balance sheet and income statement; and follow the company’s quarterly reports.
That’s just the minimum that you need to do. So if this isn’t how you want to spend your evenings and weekends, then buy an index fund, put money in it regularly and go have fun.
For everyone else, here’s how to do it.
1. Understand your stock screener. First, find a stock screener. Most online brokerages have them, and financial sites such as Yahoo Finance do, too. The screener allows you to sort by almost any characteristic you can imagine, such as annual sales growth above a certain level, say 10 percent.
Growth rates and value are relatively basic criteria, so the example in this article will screen for stocks on these dimensions. Better screeners will offer more criteria and more customization.
2. Search for companies that perform. You can define good companies in many ways, but a typical one is how fast the company is growing. Quick-growing companies tend to be valued more highly by investors, so they’re a good place to begin your search for companies.
Set up a screen for a company’s future earnings growth rate. You’ll want to search for companies that analysts expect to grow earnings greater than 10 percent annually over the next five years. You can increase this to 15 percent or even 20 percent. Earnings growth above 20 percent is very high.
If the screener doesn’t have a screen for future earnings growth, then use a screen for sales growth. Again, search for companies increasing sales (also called revenue) faster than 10 percent. And if the screener doesn’t have future earnings projections, find earnings or sales growth for the past five years instead.
3. Focus on value. You’ve got a list of fast-growing companies. Let’s add another criterion to the screen and search for companies that are also inexpensive.
Note that “inexpensive” here is referring to stocks that offer good value for the money, and not just stocks with a low share price. There are plenty of stocks that offer a low share price, but in many cases, you may be getting what you paid for.
To evaluate a stock’s value, investors will often divide the current price of one of its shares by its annual earnings per share. The resulting number is called the price-earnings ratio, or P/E ratio. The lower the P/E, the cheaper the company is. For example, investors might be willing to buy Facebook stock at a P/E of 20 this year, while they paid a P/E of 30 last year. If you pay a lower price for the earnings, you’re getting a better deal.
On the screener, add another criterion for the company’s current P/E ratio. There’s no hard-and-fast rule on what P/E ratio is cheap, but a P/E below 16 is a reasonable yardstick.
4. Dig deeper. The screener should leave you with dozens of companies that are relatively cheap and that analysts think will increase earnings well in the future.
If you end up with more companies than you need, you can add some other criteria:
Set the minimum size of the company, as measured by its market cap, to avoid the smaller, riskier stocks.
Increase the minimum growth rate, to 15 percent growth instead of 10 percent, for example.
Screen for stocks trading near their 52-week low point, to ferret out those that the market has soured on (for now).
But the screener is just the start of finding a good, cheap stock. From here you really have to dig into the company. You’ll want to figure out:
If this is such an attractive high-growth stock, why does it look cheap? What does the company do? And does the industry have a future? How is the management, and is it aligned with shareholders? How do the company’s balance sheet and other financials appear?
Answering these fundamental questions is a big task, especially if you’re aiming to have a well-diversified portfolio of about 20 companies, a typical benchmark for being diversified. And after you’ve purchased your stocks, you’ll want to keep up with the companies by analyzing at least the quarterly earnings reports.
If you’re looking to dig into investing in stocks, open an account with a broker that provides good screening and research, including analysts who can help you get started.
James Royal writes for NerdWallet. E-mail: email@example.com. Twitter: @JimRoyalPhD.