How To Identify Good Stocks: Stock Picking Explained For Beginners

There are only a couple of ways to identify good stocks for investing. Either we can do it ourselves or let the experts do it for us. But a piece of expert advice has a cost. Moreover, experts may not be available for people like us who can invest only a few thousand each month. Furthermore, whom we may recognize as experts may not be as reliable.

Now, bundle the cost, availability, and reliability factor of experts together. You will realize that DIY stock investing is better. So in this article, we will learn how beginners can identify good stocks on their own.

Beginners can also use an Excel sheet as a tool to analyze stocks. But for the moment, let’s not talk about the tools. We will focus primarily on building an understanding of how to identify good stocks. We can do it just by looking at their numbers.

Which are good stocks?

A growing and profitable company run by able managers makes it a good buy? No, it’s stocks must also be available at a discounted price. Only then, it’s a good buy.

So for us, there are four parameters to focus on:

1. How fast the company will grow?
2. How profitable is the company’s business?
3. Is the company run by able managers?
4. The company’s stock is undervalued or overvalued?

The answer to these four questions can help us identify good stocks. We will see how to give answers to these four questions. 

But there is a hurdle related to the practical application of this knowledge. We will learn more about it later and how I manage this issue.

But before that, allow me to explain the four parameters based on which we can identify good stocks.

4 Parameter To Identify Good Stocks

My stock analysis worksheet can analyze stocks based on six parameters, growth, profitability, management, financial health, economic moat, and price. But to address the topic of stock analysis here, we will limit our discussion to the following four only.

#1. Growth

How fast a company can grow on its own? The answer is in the term called self-financeable growth rate (SFG). It is a growth rate at which the company will not need external financing to fund its growth. To know more about it, check this post on SFG.

In this article, I’ll keep it simple. Generally speaking, companies need capital to grow. But from where it’ll come? There are two sources, net profit (equity) and borrowed money (LT debt).

The infographic shown above tells us about the portion of the profit (PAT) available for the company’s growth. The company can’t use all of the PAT for its growth. Why? 

The company will pay dividends to its shareholders. It will also need capital to do the necessary maintenance and replacement of buildings, machines, etc. We can use D&A (Depreciation and Amortization) as a substitute for the Maintenance Capex.

So, the formula for the profit available for growth (Pg) is shown below:

Pg = Net Profit – Dividends – D&A

What is Pg? It is the residual profit that remains in the hand of the company after making the adjustments. The company must adjust it for the dividends and provisioning for the maintenance needs.

The logic is, the residual profit (Pg) gets added to the company’s total capital. The percentage times the Pg will enhance the total capital at that rate the company will grow. This value we can use as the company’s future growth rate..

We must also remember that only long-term debt can contribute to the future growth of the company.

Future Growth Rate = Pg / (Equity + LT Debt)

#2. Profitability

The point of doing a profitability analysis of a company is to check if it is a value creator or value destroyer. How to judge it? By comparing the company’s profitability and cost of capital.

For a company to be a value creator, its profitability must be higher than its cost of capital. To know more about the cost of capital, check the provided link.

Which metric is best to judge the company’s profitability? One of the better ratios to be used here is Return on Invested Capital (ROIC). Read more about how to do a detailed analysis of profit margins.

The higher is the ROIC, above the cost of capital (WACC), the better is the company for investment consideration.

#3. Management

There is a detailed article on the topic of quality of management of a company. I’ll suggest you kindly read that post.

As a beginner, we can consider a company’s management doing fine work if the following three things are happening at a tandem:

• (a) Sales Growth: Open the last 10-years profit and loss accounts of a company and check its sales numbers. You would like to see a growing trend. Growing sales over 7-10 years are not as easy as it might sound. It takes a lot of initiatives from the management of the company to achieve it.
• (b) EPS Growth: Sales growth must translate into benefits for the shareholders. It is less likely to happen if EPS is not growing. Now, if sales are growing and EPS is not growing, there are two reasons for it. Unproportional expense growth or liquidation of outstanding shares in the market. Good managers always keep both these parameters in firm control. The bigger purpose is to ensure shareholder value.
• (b) Profitability is Stable: The management has to work hardest to maintain or improve the company’s profitability. Calculate the ROIC of the company for the last 10-Yrs. A combination of increasing sales and stable ROIC talks a lot about the management’s quality.

#4. Price

A growing and profitable company run by able managers might sound impressive, but more is needed. Investors cannot buy stocks of a company if the company has fared well on the three parameters shown above. One extra touch is needed.

Everything has a fair price. Onions can cost about Rs.20 per kg. But gold’s price is about Rs.49,00,000 per kg. Even though onion has its utility, but one will not buy onions at gold’s price.

Similarly, a company’s stocks may look impressive upon fundamental analysis, but it is not purchasable if it is trading at overvalued prices. How to check if the company’s stock is undervalued or not? There are three steps:

The Three Steps

• Step#1: Calculate the stock’s P/E and PEG ratio. If the stock’s P/E ratio is between the 15-20 range, it may not be overvalued. But a surer indicator of undervaluation is a PEG ratio of below 1.2.

• Step#2: The second step will give a better hint about the valuation. Here one must plot a five-year PE chart. As shown in the above example, the PE of the company grew from 9.5 to 76 in the last 5-Yrs. Rising PE is a clear sign of overvaluation. One can also calculate the PEG of the past years. What we would like to see is a falling PEG ratio. As shown in the below example, PEG was one (1) when the price was at Rs.201 levels.

• Step#3: In this step, we will compare the PE ratio of our company with its peers. This exercise will give an approximate idea about the current PE levels of the industry. In my stock analysis worksheet, stocks of similar companies in the sector are compared. Comparing PE like this gives a fair idea about the price valuation.

A Practical Hurdle

There are more than 3,000 number stocks listed in the stock market. It will be impractical to analyze all shares using the above four parameters. What is the solution? It is where stock screeners come in handy. The screeners substantially shorten the list of stocks.

Generally, I used the screener to prepare my watchlist of 20-30 stocks. Once the list is ready, I’ll analyze these stocks based on the discussed parameters.

Conclusion

Deep stock analysis is a domain of experts. But it does not mean that DIY stock analysis is not possible. I’ve learned that relying on one’s analysis is better than outside advice.

If we can analyze a company for its future growth prospects, current profitability, quality of management, and price valuation, that’s it. 

I hope you liked the article. Have a happy investing.