Stock Selection To Maximize Returns

Good stock selection is vital for investment success, but many small investors don't know what to look for. In this article we'll identify five key items that may be important when picking companies to invest in.

1. Earnings
Is the company profitable? The first factor in stock selection is the most basic. A company that's making money is probably a better bet than a company having trouble paying the bills. So the first item to look at are earnings and sales. Don't just look at the last quarter, check for trends. If earnings have been plummeting over the last year, the company could be headed for trouble.

2. Price to Earning Ratio
The price to earnings ratio or P/E probably stands out as one of the biggest factors used in stock selection. This is the price of one share of stock divided by the earnings per share. So, if a company stock is selling at $30 per share, and the earnings per share are $2, the P/E = $30 / $ 2 = 15. The long-term average of the S & P 500 is 15. So as a rule of thumb, if P/E is a lot larger than 15, the stock may be over-priced and could be headed for losses in the near future. On the other hand, if the P/E is less than 15, the stock may be positioned for a rise in price. P/E must be examined in a larger context. For example, certain market sectors have different average P/E ratios. So when evaluating a particular stock, you should look at comparable companies in the market sector. Growth is also important.

3. PEG Ratio
Another factor besides earnings now in stock selection are potential earnings in the future. In other words, is the company growing rapidly? If so, the company may be a good buy even if it has a P/E ratio that's higher than average. The PEG ratio is P/E / (annual earnings growth rate). If a PEG ratio is lower, its a more attractive stock, as a lower PEG ratio generally means a higher annual earnings growth rate. If the PEG ratio is near 1, its considered a good buy. If PEG ratio is less than 1, the stock may be a really good buy.

4. Price-to-book
Book value is a measure of a companies assets after liabilities have been deducted. Value oriented investors will be more interested in price-to-book than PEG ratio. In addition, looking at book value helps investors with stock selection by weeding out earnings spikes that could come from a sale in assets, for example. If a company sells of some assets, its earnings may be momentarily inflated, but its book value will drop. So you can check the price-to-book as a back-up to P/E ratio and PEG ratio. Price to book is calculated as the price per share/ book value per share.

5. Profit Margin
Following earnings, you probably want a company with good profit margin. Profit margin is simply net income/sales. This information is available in the companies financial report.
Stock Selection Tip: Read Financial Reports at Morningstar.com
Do your picks carefully. Of course, picking which companies to invest in often comes down to intuition as much as it does looking into these parameters. To learn more about stock selection and investing, click on the image below to learn about our beginners stock market investing guide, Investment for Wealth.