How to select good Stocks for long-term investment?
How to select good Stocks for long-term investment?
Nowadays, people understand the value of investing and want to invest their money in the stock market for the long term. But some of them are confused and put themselves into trouble by selecting the wrong companies. It mostly happens when the investors are not aware of the Fundamental Analysis and economic indicators properly. To select good stocks for long-term, you have to understand the significance of indicators as well as you have to prepare yourself for the long-term goals by being focused, disciplined, and updated.
As uncertain as the stock market is, long-term investors must identify a few aspects of the securities they shortlist for buying to increase their chances of succeeding in the longer run. According to one of the most successful investors, it is important to focus on the “Quality of Stocks” rather than the “Quantity of Stocks”. Yes, you guessed it right - these are the words of the great WARREN BUFFET!
To distinguish stocks that have the potential to deliver solids in the mid to long run, investors must assess both the subjective and quantitative elements of the securities and how they would impact the Return on Investment (RoI) in the days to come.
Given below are some important factors that an investor must know before investing in this volatile market to reap fruitful returns in the longer run.
The methodologies listed below can be used to determine the value of a stock.
Start by looking at the P/E Ratio
P/E ratio stands for ‘Price/Earnings ratio’ which is mainly helpful for determining whether a stock is overvalued or undervalued. The P/E ratio can be calculated by using the mathematics division rule. The current stock price is divided by the earnings per share of the company, that assists investors to determine the correct market value of the stocks as compared to the company’s earnings. In this, a Higher P/E ratio indicates that a stock’s price is on the rise as compared to the earnings and probably overvalued. Similarly, a low P/E ratio implies that the current stock price is low as compared to the earnings.
Although the P/E ratio is an important metric to determine how the security will perform in future years, one should not only consider the P/E ratio for long-term investments. In simple words, a low P/E ratio does not suggest that a stock is underperforming or vice-versa. One must use the P/E ratio with other tools for a better understanding.
How Strong the Company is Compared to its Peers?
A great way to analyze a stock’s long-term potential is by comparing it with several other companies functioning in the same space. While doing so, one can take into account various parameters like free cash flow, net worth, year-on-year growth, asset value, vision regarding their business and others to shortlist a handful of stocks worth investing in long-term. It is also important to ask a few questions such as the ones given below before finally investing in the stock -
- How does the target company fare against its competitors?
- What advantages do the target company have over its rivals?
It is also important that the investors take into account those companies that have similar market capitalization. Once done correctly, this pointer can put out some valued investment opportunities.
Debt to Equity Ratio
The “Debt-to-Equity” ratio is one of the most important factors to be considered by long-term investors as this aspect defines the financial health of companies. The debt-to-equity ratio can be simply explained as the “amount of debt against each share of a company”. A high debt-to-equity ratio means most of the company’s profits will be used to clear debts. It, by no means, suggests that companies with higher D/E ratios cannot be profitable to their shareholders (look at Apple and Amazon). The companies should, however, be able to explain their high D/E ratio to investors.
Given below is the formula to calculate the debt-to-equity ratio of an available company -
D/E = Total debt on the company ÷ total equity distributed among the shareholders
The Leadership of a Company
Evaluating the leadership of a company is equally important to the pointers mentioned above during shortlisting a stock for long-term investment. While looking at this parameter, the investor must have the answer to one question - Is the leadership of the company trustworthy? Well-managed companies show an increased footing in their respective industries resulting in higher stock prices over a while. It is also important for the investor to find out how well the company leadership communicates with the shareholders.
Long Term Stability
The volatility of the stock market makes it an unpredictable place to be invested in. There are times when companies’ shares lose their values but only good companies turn around after weathering the storm. This characteristic differentiates “stable” companies from others. Readers must understand long-term stability comes with strong leadership, a low debt-to-equity ratio, the position of the company compared to its peers in the industry, and steady revenue growth. Companies failing to fulfill any of the aforementioned criteria must be taken a close look at to determine their long-term return.
Consistency in Dividends
Dividends show the distribution of organisation profits to shareholders depending on the number of shares they own. It also demonstrates that the organisation is financially sound enough to pay dividends. But there are plenty of suggestions on how many years you should look back to find this consistency. No matter how many suggestions there are, it will give you an indication of dividend consistency. Many renowned investors like Rakesh Jhunjhunwala, Warren Buffet, Charlie Munger have created their own dividend empires that acts as a passive income source for them.
Avoid Value Traps
When you have to identify that the stock is a good long-term investment and not a value trap then you must go through the company’s debt ratio and current ratio. The measurement debt ratio lets you know how much debt has been used to fund assets. To calculate the debt ratio, you need to divide the total liabilities by the total assets of the company. Basically, the larger the debt, the more likely that company is to become a value trap.
To calculate the current ratio, you need to divide the current assets by the current liabilities of the company. In any case, the larger the number, the more likely liquid the company is.
Keep an eye out for fluctuating earnings
The economy is cyclical. When the economy is doing well, incomes grow. At other times, the economy is stalling and wages are dropping. Examining a stock's previous earnings and future earnings estimates is one approach to see if it's a smart long-term investment. It could be a smart long-term investment if the company has a continuous history of rising earnings over a lengthy period.
Here is the quick recap to determine the efficiency of good companies for smart long term investments:
- Strategy and goals
- Financial Ratios ROE and ROCE
- Promoters buying and share buybacks
- Perks and compensations to staff and workers
- Length of tenure of management
Few suggestions that should be implemented before selecting any stock to invest in:
- For better returns, invest in Mid-Cap Companies
- There is no relation between past achievements and future success
- Overvalued isn’t always bad, undervalued isn’t always good.
Investing for the long run needs patience and discipline. When the company and markets aren’t performing well, you can spot good long-term investments. You can track easily such hidden diamonds in the rough and prevent potential value traps by just using fundamental tools and economic indicators.
1). Which are the best stocks to invest in for beginners?
Ans: Beginners should focus more on large cap companies with stable share prices like Reliance Industries Ltd, Hindustan Unilever Ltd, HDFC Bank, Maruti Suzuki India Ltd etc.
2). Are the pointers mentioned above relevant for intraday or positional trading?
Ans: No, the pointers mentioned above are only relevant for long-term investment. For intraday and positional trading. You required Technical analysis of stocks is more important than their fundamental analysis.
3). Are the aforementioned pointers relevant to identifying multibagger stocks also?
Ans: No, not all the pointers mentioned in the aforementioned piece are relevant in identifying multibagger stocks. However, ratios like P/E and D/E ratio are important pointers while analyzing stocks from the multi-bagger perspective.
4). Can I use these pointers to invest in small-cap stocks for a longer duration?
Ans: Yes, you can use the pointers mentioned above to shortlist small-cap stocks for long-term investment.