With so many public companies, how do professional investors find good companies to invest in and those to short or just ignore? These are all valid questions if you are looking to start investing in the stock market. To begin you need a good understanding of how the stock market works, what moves stocks, and how to find good investment opportunities.
How the stock market works
When companies need financing, they have a number of options. They can issue debt or commercial paper from commercial banks. This money is supposed to be paid back within a certain period. They can also go to venture capitalists who will provide capital in the form of debt or equity. As they grow, they need more capital and debt becomes unsustainable. To get cheaper and more sustainable financing, they go to the public through an initial public offering (IPO). Here, they sell a certain stake to outside investors who now become shareholders. These shareholders can continue to hold the stake or they can exit at any time in the open market. When they exit, preferably at a profit, the new buyers become the new shareholders.
Therefore, since there are thousands of companies listed at different exchanges, the course of buying and selling is a continuous process. This makes the equities market a very large one because while some investors want to exit, others want to initiate positions.
What moves stocks?
To understand how to research stocks, it is important for you to understand the different factors that move stocks. The core factor is demand and supply. A company’s stock tends to move higher when there is more demand. It falls when there is no demand. This demand is created by fundamental factors. For example, when a company increases its dividend, it becomes more attractive to investors and therefore increases the demand. This causes it's stock price to rise. On the other hand, if a company slashes its dividend, the existing investors rush out at a time when no one wants to enter. This leads its stock to decline.
Other than dividends, other factors that move stocks are:
- Impressive guidance
- News of mergers and acquisitions
- Growth (or lack of)
- Change of management
- Stock repurchases
- Stock purchases by management
- Impressive economic data
- Stock purchase by an influential investor
- A positive report from sell-side analysts.
How to find companies to invest in
The first thing you need to do when researching about companies is to define the type of investor that you are. Broadly, there are three types of investors who look at different things in a company.
Day traders are investors who focus on short-term swings in the price of a stock. They initiate and exit their positions within a day. Swing traders open trades and leave them open for a few days. These investors mostly focus on technical and ongoing news. For example, they will buy a company that has just announced great results and exit the trade when the earnings news fade. They also buy companies that are oversold in the short-term charts.
Long term investors, on the other hand, are those people who buy stocks and hold them for months and years. These investors are little focused on the current news or the signals from technical indicators. To decide which companies’ stocks to invest in they follow this procedure:
Select the industry
The first step is to find the industry that you want to invest in. There are about 11 industries which include consumer staples, consumer discretionary, technology, and finance among others. It is recommended that you find an industry that you have interests in. For example, if you love the oil and gas industry, you should find companies in the sector. Equally, if you are passionate about technology, you should find investments in the technology sector.
Size of the companies
After selecting the industry, you should now determine the size of the companies you want to invest in. Some investors prefer investing in mega-cap companies that have a market valuation of more than $100 billion. Others prefer small cap stocks that are valued between $100 million and $1 billion. In all industries, you will find hundreds of companies in each of the categories.
These two steps can be accomplished simply by using the many free online tools that allow the stock screening. You can continue narrowing down the search according to other metrics like growth, historical performance, and revenues.
After narrowing the search, you likely have a number of companies. You should then select a company that you want to invest in by doing a few things.
First, you should download the company’s annual report. For United States companies, this is also known as form 10K. This document contains all the details you want to know about the company. It starts by describing the business the company is involved in. It then highlights other important issues like the competition it faces, the segments it operates in, the risks to its business and the financial results.
Second, you should follow the news about the company. This will help you stay up to date on recent developments in the company. You can find this news in the many online platforms that aggregate financial news.
Third, you should now consider the valuation of the company. The goal here is to find the real intrinsic value of the company. This is the amount of money you are willing to pay if you were given a chance to acquire it all.
There are many types of methods conducting this valuation but the most common are the discounted cash flows (DCF) and the ratio comparison.
The DCF method is a way of finding the value of a company using future cash flows. It finds the present value of future cash flows using a discount rate. It does this by using the following formula:
DCF = CF1 / (1 + r)1 + CF2 / (1 + r)2 + CFr / (1 + r)n
Where CF is the cash flow, and r is the discount rate, and n is the number of years.
In ratio comparison, the goal is to compare the multiples of a company with that of its peers. There are a number of multiples that you can compare. The most commonly used is the price to earnings ratio (PE). This is a ratio that compares the current share price and the company’s Earnings Per Share (EPS). Ideally, investors should pay a similar multiple to companies in a given sector.
For example, if the average PE ratio of companies in the oil and gas sector is 10, it means that investors are happy to pay 10 times the company’s EPS. Therefore, if the company you are considering has a PE ratio of 5, it means that it is undervalued. If it has a PE ratio of 20, it means that it is overvalued.
Qualities of a good company
As you research a company to invest in, you should consider one that has a number of qualities. These are:
Management: a good management team and board of directors is key to the success of a company. You can get the profiles of these directors in the annual report.
Simple companies: good companies with simple products you can understand make for easier investing. For example, Coca-Cola is a good company that you can understand easily.
Cash flow: the importance of healthy cash flow numbers cannot be overstated.
Returns money to shareholders: a company that rewards its investors using dividends and share buybacks is always attractive to investors.
Growth: a company that is growing its revenues, earnings, and margins is likely to show signs of a healthy future.
Insider ownership: a company whose management and directors are shareholders is better than companies with senior management without any ownership.
Start investing now
As an investor in a public company, you own part of it. This means that you can make decisions on management, cash utilization, and other issues. If you want to invest in European, Asian, and American stocks but you don’t have access to their brokers, opening an account at a CFD broker can help you do this. A CFD is a derivative that allows you to invest in security without having the need to invest in real security.