How to Pick Stocks - Easy Stock Picking Technique

Picking stocks can seem a bit like choosing your lottery numbers, so many choices and no guarantee of success. At least with stocks there is ample information to make your choice easier, so much so it can be hard knowing where to start!

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Stock picking is not an exact science, but each stock has some crucial numbers that can shed some light on the process.

Earnings per Share (EPS) = Profit Before Tax / Number of shares in issue

Quite simply this is the amount of profit earned for each share. Its main use is as an input to the

Price-Earnings (PE) ratio = Share Price / Earnings per Share

This tells you how cheap/expensive a share is. The PE ratio should be viewed in the context of the average for the market, and in particular for the average of the sector for the stock under consideration. You should also ask why the market has priced the stock as it has. A low PE ratio could mean a bargain, or (more likely) suggest some perceived problems. A high PE ratio could mean the stock is overpriced, or that the market thinks highly of it. A related indicator is the

PEG ratio = PE ratio / Expected annual growth of Earnings (%)

A low PEG ratio (<1) can indicate a bargain. A problem with PEG is that the 'Expected annual growth of Earnings' is just a forecast (guess).

Yield = Dividend per Share / Share Price

A very significant number if income is important to you.

The next two numbers indicate how well the firm is able to meet its debts.

Current Ratio = Current Assets / Current Liabilities

The higher the better. If less than 1 the firm would be unable to meet all its liabilities at this time.

Quick Ratio (Acid test) = (Current Assets - Inventory) / Current Liabilities

Similar to above but excludes inventory, leaving only assets, which could quickly be converted, to cash. This should not be significantly less than the sector average.

Net Asset Value (NAV) per Share = Net Assets / Number of shares in issue

Theoretically how much each share would receive if the business were wrapped up and its assets sold. The higher the NAV the safer the investment, but too high a figure suggests the firm itself adds little value.

Return on Investment = Operating Profit / Owner's equity

A measure of management efficiency. The higher the better.

The following two measures give an indication of risk.

Debt-to-Equity Ratio = Total Liabilities / Owners' Equity

A measure of leverage or gearing. Since payment on debt is unrelated to earnings, the higher this number the more common stockholders stand to gain from an increase in profit. It is effectively magnified. On the other hand the more stockholders lose in the event of a downturn.

A stock's beta coefficient reflects its volatility in relation to the market as a whole. A beta of 1 indicates the stock moves in line with the market, less than 1 that it moves less than the market, and more than 1 that it is more volatile. Obviously beta is calculated on past behavior, which may not be continued in future.

The higher the risk, the higher should be the (expected) return.

Remember:

 

• the numbers are calculated on past performance, and as the small print of every piece of investment literature states - past performance is no guarantee of the future;
• supporters of perfect market theory say looking at this data is pointless, because the market as a whole has already looked and adjusted prices accordingly;
• these numbers are inputs to the decision process, they alone should not make your decisions for you.

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