FRE.DM’s Guide On How To Pick Stocks/Shares
Choosing the right stocks/shares can feel like stepping into uncharted territory, especially with the ever-changing dynamics of the stock market. But that’s where your trusted guide, FRE.DM Wealth, comes in to help you navigate and give you a map to get started.
In this handy guide, we’ll break down practical steps to help you make informed, confident decisions as you begin your investing journey, without relying solely on gut feelings or market hype.
Let’s get into it.
First and foremost, the first step is to identify your investing goals.
There are various strategies when it comes to investing, and it’s incredibly beneficial to figure out what yours are from the start. This gives you clarity on your goals and helps you map out the path to achieve them.
For example, are you an older investor focused on capital preservation as you near retirement and want to live off your holdings? Or are you a younger investor aiming to grow your portfolio as much as possible over many years? Maybe you’re somewhere in between, seeking stability with extra investment income.
Once you’ve identified your goals, you can start exploring where to invest.
If you’re aiming for growth, you might be drawn to younger companies with promising revenue growth, even if their earnings aren’t yet stable. If capital preservation is your priority, you may prefer stalwart businesses with decades of steady, predictable profits. Alternatively, if you’re looking for extra income, stocks with solid dividend yields and the cash flow to support those dividends will be your focus.
Your next step – Seek out companies that make sense to you.
When you buy stock/shares, you become a partial owner of a business, so it’s crucial to find businesses that not only align with your values but that you also understand. This is a key element in setting yourself up for success.
With so many companies out there — from the brands you stock in your fridge and pantry to the stores you shop at for essentials and non-essentials — there’s bound to be one that resonates with you.
Once you’ve identified a few companies you understand and can support ethically and financially, it’s time to research them.
Are you confident enough that if you were given full ownership of the company, you’d have a solid sense of how it runs and what it needs, or whether the staff are doing a good job?
A basic understanding of the company's operations is vital and a smart way to begin your investing journey.
To truly walk the walk, make a list of the companies that align with your values, identify their competitors, and then dive into researching the ins and outs of each one.
Your third step to tackle – Determine if the companies you’re considering have a competitive advantage.
It’s time to start narrowing down your list.
A key attribute of a successful business is a sustainable competitive advantage.
So, what exactly is a competitive advantage? It’s a company’s ability to produce goods or services more efficiently, or at a higher quality, than its competitors.
Finding companies that have a strong advantage over others in their industry is essential.
Warren Buffett often refers to this as a “moat.” In an interview with Fortune, he explained, “The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage. The products or services that have wide, sustainable moats around them are the ones that deliver rewards to investors.”
There are many forms of competitive moats to look for in the companies on your list—
Switching Costs – These are the burdens or inconveniences customers face when switching from one provider to another.
Examples include:
Psychological costs - Apple users may hesitate to switch to Android due to familiarity with the Apple ecosystem.
Time-based costs - Switching phone plans might require driving to a store or spending time on the phone with customer service.
Financial costs - If you have a year-long subscription to a language app and switch to another, you lose the remaining value of your original subscription.
Exit fees - Fees charged by companies to discourage leaving, such as early termination fees for internet services.
Scale – This refers to growing a company in a way that increases revenue while keeping costs manageable.
This involves:
Having a clear growth plan with the right systems, staff, processes, technology, and partners.
Securing sufficient funding to support growth.
Preparing for spikes in demand by maintaining enough inventory and a smooth order fulfilment process.
Developing recurring revenue streams.
Intellectual Property – These are intangible assets created by the mind, such as inventions, code, designs, logos, brand names, and formulas. They can be highly valuable for businesses, giving them a unique competitive edge.
Network Effect – This occurs when the value of a product or service increases as more people use it. Social media apps are a great example — each new user adds value to the overall platform, making it more attractive to others.
Unique Brands – These are products or services with a distinctive identity that sets them apart. Examples include Coca-Cola, Nike, Tesla, and Airbnb, all of which have strong brand recognition and differentiation.
Now that you've explored your list of companies and the specific moats they have, it's time for the fourth step – determining a fair price for the stock.
There are several ways to evaluate a stock’s current price and whether it’s worth buying. Here are a few strategies you can apply to your list of potential stocks –
Price-To-Sales Ratio (P/S): This is calculated by dividing the stock’s current price by the company’s sales (or revenue) per share. It tells you how much investors are willing to pay for each dollar of a company’s sales. For example, if a company has a P/S ratio of 2, investors are paying $2 for every $1 of the company’s sales. A lower P/S can indicate the stock is undervalued, while a higher P/S may suggest it's overvalued — though it’s important to compare this ratio with similar companies in the same industry.
Price-To-Earnings Ratio (P/E): The P/E ratio is calculated by dividing the stock’s current price by its earnings per share (EPS). It shows how much investors are paying for each dollar the company earns. For instance, if a stock has a P/E of 20, investors are paying $20 for every $1 of earnings. A higher P/E may indicate that investors expect future growth, while a lower P/E could suggest the stock is undervalued or facing challenges. Be sure to compare P/E ratios with industry peers for a better perspective.
Dividend Yield: This is a measure of how much income you can expect from a stock based on the dividends it pays. It’s calculated by dividing the annual dividend payment by the current stock price. For example, if a company pays $2 in dividends per year and its stock price is $50, the dividend yield is 4% ($2 ÷ $50 = 0.04 or 4%). While a high dividend yield can be attractive, it’s essential to assess whether the company can sustain those dividend payments over time.
Discounted Cash Flow Modeling (DCF): This method estimates a company’s value by predicting its future cash flows. The concept is that money in the future is worth less than money today due to inflation and other factors. DCF adjusts future cash flows to reflect their present value by applying a discount rate (which accounts for risk and time). Essentially, you project how much cash a company will generate, then ‘discount’ those future cash flows back to today’s terms. If the calculated value is higher than the current stock price, the stock may be undervalued and worth considering.
Lastly, once you’ve assessed whether the stock you’re considering is offering a fair price, the next step is to think about buying with a margin of safety.
After narrowing down your list of stocks based on fair asking prices, ensure they fall below your estimated intrinsic value. A margin of safety indicates how much buffer you have between the stock’s current price and its intrinsic value.
For example, if the intrinsic value is $10 per share and the current price is $7.50, there’s a 25% margin of safety. The higher the margin of safety, the less risk your investment entails. A stock with a 50% margin of safety is theoretically less likely to decline than one with a slim margin or none at all.
Using this margin of safety to guide your investment decisions is often associated with value investing, though growth investors should also pay attention to it.
Value investors typically utilise one of the following methods to determine a stock’s intrinsic value –
Discounted Cash Flow Model (DCF): We discussed this earlier!
Liquidation Value: This method assesses what the company would be worth if it were broken up and sold off.
Multiples: This approach involves comparing metrics such as price/sales, price/book, or price/earnings to gauge how the stock stands against its competitors, the broader market, or its historical performance.
Essentially, aim to find a quality, easy-to-understand business with strong management and only purchase stocks that offer a sufficient margin of safety.
While a margin of safety is a surefire way to measure risk and ensure you’re investing in stocks with potential for good returns, it’s crucial to conduct thorough research to accurately value the companies you’re interested in and determine what percentage you’re comfortable with as a safety net.
Above all else, once you’ve put in the work, take a deep breath and trust yourself. You don’t always need to secure the absolute lowest price for a stock. By building a diversified portfolio across different industries, you’re more likely to pick some winning investments.
After reading this blog and following our steps, if you still feel you need a guiding hand in choosing a diversified portfolio filled with solid stock choices, reach out to us here at FRE.DM Wealth. Our doors are open, and we’re eager to help you create the abundant life you’ve always dreamed of. With our extensive knowledge in this arena, we’re here to support you. Investing in stocks can be daunting at first, but once you get your feet wet, you’ll find yourself building an incredible portfolio that you can be proud of—especially with our help.
*NOTE: THIS BLOG IS FOR EDUCATIONAL PURPOSES AND DOES NOT CONSTITUTE SPECIFIC ADVICE.
