How to Pick Great Stocks

The article Common Traits of the Best Stocks discussed what to look for when picking stocks. You want companies that have

 

• above-average sales and earnings growth,
• stable or growing profitability, and
• a current price, as measured by the price-earnings ratio, that’s reasonable.

If you see that a company has above-average sales and earnings growth — the more consistent, the better — and stable or growing profitability, there’s a good chance it’s a well-managed, high-quality company. You’ll then want to see whether the current stock price offers a potential return.

 
BetterInvesting has molded these concepts into an investment strategy and stock selection and analysis process that will help you buy individual stocks. Anyone with the determination to remain focused on long-term results can build a portfolio of around 10 to 20 stocks that has to potential to outperform the S&P 500 or other index fund.
 
Our process focuses on finding quality growth stocks selling at reasonable P/E ratios for long-term gain. BetterInvesting’s approach to stock analysis is that sales drive earnings, and earnings drive stock prices. Some people trade on short-term up and down ticks in stock prices, but over the long term fundamental analysis — studying a company’s financial performance — is what works in building wealth.

Since 1951 BetterInvesting members have used the Stock Selection Guide to study stocks, and there’s some math involved. But our online stock selection and analysis tools automatically import the critical data from company financial statements and do the calculations for you. So after reading the article, learn more about our online stock selection and analysis tools and sample our education and resources for free.

Step 1: Forecast Long-Term Sales Growth

In the short term, the stock market may not reward individual stocks for their excellence. But over the long term, stocks prices move upward with earnings growth. So it’s the long-term projections — five years, very roughly enough for the company to go through a business cycle — you’ll care about.

You start by forecasting five-year annual sales growth, because as we said, sales drive earnings. You’ll use this estimate to build your earnings projection. You have a number of data points at your disposal, including

•  the company’s historical growth rate,
•  company statements regarding growth goals,
•  Wall Street estimates, and

•  the industry’s historical growth rate and estimates of future expansion.

Step 2: Forecast Long-Term Earnings Growth

You then estimate five-year annual earnings growth in light of the sales projection. You can consider the company’s history of earnings growth and any goals it has stated. You can also access analyst reports and analysts’ consensus estimates, but these forecasts are usually optimistic. Often the best move is to use a similar rate as the sales growth forecast.

The earnings growth rate determines the estimate of earnings per share five years from now. If you’ve estimated earnings growth of 15 percent a year, and the EPS at the starting point is $1, five years from now EPS will be $2.

Step 3: Estimate the Future High and Low Stock Price

The EPS estimate is critical for the next stage: determining whether the stock is reasonably priced. Investors are good at discovering high-quality stocks but often buy stocks at the wrong price.
 
Using historical P/Es as a guide, you forecast the high and low P/Es over the next five years. At this point you’re ready to estimate a potential high price for the stock. It’s simple math: You multiply the estimated EPS in five years by the forecast high P/E. For example, if you predict EPS will be $2 in five years and the high P/E will be 30, the predicted high price will be $60.
  
For the low price, you multiply the projected low P/E by the expected low EPS to come up with a potential low price. For a quality growth company, you usually assume that the most recent year’s EPS is the low. BetterInvesting’s stock analysis process has other options for the low price, but this is the most common one.

Step 4: Determine the Individual Stock's Return Expectations

After you determine the stock’s potential range over the next five years, you’re ready to see whether this stock will provide a suitable return. Our SSG divides the range into three zones: Buy, Hold, and Sell. The lowest 25 percent of the range is the Buy zone, and the uppermost 25 percent is the Sell zone. Again, our online tools handle the math for you here.

The stock’s dividends — the cash payments of earnings to shareholders — is included in return calculations. So there are three ways to achieve a return on a stock: through dividends, through the market increasing the stock’s price in concert with the earnings growth and through the stock’s price rising because the market believes the P/E should be higher.

When picking stocks, aim for return of 15% annually on average over the next five years, or a doubling of return. That’s an aggressive target, but don’t be disappointed if you don’t meet it. The idea is to maintain your focus on buying stocks of high-quality, growing companies. Achieving returns of, say, 10 percent yearly — about the historical return of the S&P 500 — is commendable.

In today’s unpredictable, volatile market, fundamental analysis is even more important than usual. But for an investor using a simple, straightforward methodology that focuses on the long term, these are also times of great opportunity.

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