For many investors, picking stocks seems like gambling in a casino. No matter what they do, they tend to choose wrong. Yet, you can avoid this bewilderment and improve results by using a sensible stock-selection method.
What method is best for you depends on who you are. Warren Buffett advises investing only in companies that you understand. But if you're like me, your familiarity with individual companies is too narrow to have enough stocks to choose from.
What if there were a way to pick stocks without knowing much about the companies? There is. Instead of requiring you to pore over reams of performance data, a fairly simple method focuses on three basic concepts:
Earnings growth. Earnings are company profits, and earnings per share (EPS) are the portion of these profits allocated to each share of stock outstanding. Rising EPS usually means a rising share price. Trailing earnings usually refers to the EPS figure reported for the last four quarters. Just as significant are forward earnings — analysts' estimates of future EPS.
Good earnings and forward earnings can support a broader decision to buy a stock — instead of, say, a certificate of deposit (CD), which carries far lower risk than stocks but far less upside.
Price/earnings ratio. The top number of the P/E ratio is the current price of a stock and the bottom is its current earnings-per-share figure. So if you pay $20 for a share of stock and each share earns $2, the stock has a P/E ratio of 10. The goal is to get the lowest possible P/E because this means you're paying a low price for relatively high earnings.
The historical average for P/Es is in the neighborhood of 15 or 16. For some stocks, it has run as low as 4.8 and as high as 44. Though a low or moderate P/E is generally desirable, too low a number might be a sign that a stock's price is being depressed by negative factors. Again, you need to see enough upside to compensate for the risk of buying a stock instead of a lower-risk investment like a CD.
Dividends. This is a check in the mail from the company whose stock you own. Consistent quarterly payments to shareholders out of company profits are a classic sign of a company's long-term financial health. And after all, eventually getting money back on your investment is the reason you buy stocks in the first place.
Dividends typically come from mature companies that don't need to put profits back into the business. Though younger, faster-growing companies tend to have better share-price growth than older, mature companies, they often don't pay dividends because they need all of their profits to fund growth opportunities. (If you can find a company with good share-price growth as well as dividends, buy the shares.)
Although looking for consistent dividends is a tried-and-true investing strategy, you shouldn't limit your portfolio to these companies. If you do, you'll probably miss out on some great stocks. Yet, according to a recent study of the S&P 500, 44 percent of the index's total return over the past 80 years has come from dividends. So, disregard dividends at your peril.