SINGAPORE (June 18): When it comes to investing in the stock market, there are several ways to go about it, including buying individual securities, real estate investment trusts (REITs), exchange-traded funds (ETFs), or commodities like gold, silver, and oil.
For individual securities, you should already be familiar with names such as DBS, Singtel, Jumbo, and Genting in Singapore, or Facebook, Amazon, Apple, Netflix, and Alphabet (the parent company of Google) in the US.
See: how to buy stocks in the US market
How then, do you select a stock or stocks to invest in?
It is not enough to simply look at its price and its price movement from the charts. You will also have to understand what the company does, and the industry it is in.
When buying into a stock, you are essentially paying to own a fraction of the company. With that, you want a stock that has good value, offers sustainable dividends, and has potential for growth, especially if you intend to hold it for the long-term.
Knowing the industry the company is in matters as well. For instance, take care not to invest in sunset industries, or industries that are no longer as important today. What you really want, is a company that represents an essential service or good that consumers will still want even in bad times.
Before investing in a particular company or industry, you will also have to look at these factors to determine whether the stock is worth buying into.
These factors include potential to grow earnings, price-to-earnings ratio (P/E ratio), cash and cash equivalents, debt-equity ratio, dividend yield, and its management, to name a few.
You should be able to find these factors in the company’s annual reports and financial statements.
Learn how to analyse financial statements here.
Here are the factors:
1. Return on invested capital (ROIC)
Look at the company’s financial statements to determine how much money they are making with every dollar spent. For instance, if the company spends a dollar on product development and marketing, they should be making more than a dollar in sales for the same product. The ratio is also a good way to determine if the company is using its money to generate good returns.
The formula for ROIC is to take net income minus dividends, and divide the sum by the sum of the company’s debt and equity.
2. P/E ratio
A high P/E ratio means the price of a stock is high compared to its earnings. Conversely, a low P/E ratio means the price of a stock is low compared to its earnings. A low P/E ratio may also mean a stock is undervalued. However, it does not mean that stocks with high P/E ratios are not worth investing in. For instance, Amazon has a high P/E ratio due to market sentiment on Amazon’s future earnings potential. That does not mean Amazon is not worth looking into, though. For certain industries such as real estate, you will have to look at more than the P/E ratio as well, but other measurements such as price to book ratio as well.
3. Cash and cash equivalents
A company with a larger amount of cash and cash equivalents would be able to tide it through lower periods. However, keep in mind its operating strategy, as you don’t want the said company to simply sit on cash “just because”.
However, this should be compared relative to its debt. If the company has more debt to settle over the short term, they could be distressed. Therefore, as long as the company reports a healthy amount of net cash, this should help it weather through the bad times.
4. Stability
This is key to a company’s longer-term prospects. Is a company able to turn in a certain level of earnings consistently, or are there wild swings quarter by quarter, year by year? A financially-stable business allows for more opportunities, which could lead to further, sustainable growth.
5. Debt-to-equity ratio
This ratio, which is a measure of how a company is financing its operations, is calculated by taking a company’s total debt, and dividing it by its total equity.
6. Dividends
Dividends are a portion of profits a company shares with its investors. Whether for regular investors or passive investors, a generous dividend payout is always something welcomed. However, you will also have to look at the company’s business strategy. In low periods such as the Covid-19 pandemic, you will find some companies that prefer to retain dividends to tide them through this period, as a form of stability management. Many of the REITs, for example, have done that.
7. Management
A good management team will be able to identify business opportunities and minimise risks. Is the management team led by a controlling shareholder, who, in many cases, founded the company? In such cases, these founders typically have a significant proportion of their net worth in the company. So, it is in their personal interest for the companies they own and run to do well. Minority shareholders can perhaps if they want to ride along.
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