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How to Choose Winning Stocks
Choosing the right stock to invest in needs time and care; it is never something that can be done on a whim. From the type of company you are investing in and its financial status to overall market conditions and the need to mitigate risk, there are a variety of considerations one should make before adding a stock to their portfolio.
On this page, we have provided a handy and easy-to-follow guide to finding stock winners. We cover the following topics:
- Metrics to consider when selecting stocks
- Steps to consider before investing
- Why fundamental analysis is important when buying a stock
- Why technical analysis is important when buying a stock
By the end of this guide, you will be better equipped to choose the best stocks to invest in at the most favourable time.
I. Steps to consider before investing
Before we cover the technical indicators that can be key to finding winning stocks, we need to start with something even more important: you.
The needs of an individual investor are often something that can be overlooked when the masses clamour for the next big thing, but it is crucial to know that there is no one-size-fits-all approach. Everyone is different, so let’s hone in on your financial needs and investment goals:
- Identify what kind of investor you are – Do you have an appetite for high risks with accelerated returns, or would you prefer to invest in something safer that provides steady, stable growth? Are you looking to accelerate your profits, or are you happy to sit back and watch things take their course?
Before you put any of your capital on the line, make sure you understand your own financial goals so you can formulate a personalised investment strategy, including a desired timeframe. Check out our lesson on this topic for a more detailed explanation.
- Set a budget and stick to it – Make sure that the budget you set is a realistic amount that you won’t lose sleep over should an investment unexpectedly go wrong. We have a lesson explaining how to set an appropriate budget on our website
Once you have arranged your own personal checklist, it’s time to take a look at broader market conditions before honing in on individual stocks. Here are some of the most important economic factors to review:
- Check the health of the overall economy – Unless you’re a highly experienced investor or trader, it’s never a good idea to buy stocks while the economy is in a recession, which is a business cycle contraction when there is a general decline in economic activity and stock prices fall across the board.
This is because even good companies can struggle on the stock market during a recession, meaning a stock that would be a winner in normal circumstances could still perform poorly.
- Check the trend of the market – Are the major indices indicating that the market is in a bull market (when prices are broadly moving upwards) or a bear market (when prices are broadly trending downwards)? If you’re a new investor, it is best to buy stocks when the overall market is bullish because this makes things simpler.
- Identify the type of stocks you’re ready to invest in – Are you investing in blue chip stocks only or are you ready to play with smaller-cap stocks? Is your focus on growth stocks or are value stocks of particular interest? Your list of personal criteria from the previous section should help you identify your desired stock types.
You can find out all about the different kinds of stocks in this helpful guide, which provides an in-depth look at the types of companies that are available for you to invest in and takes you through how to choose between them.
Having a solid base of understanding can help you anticipate risks like widespread corrections, economic recessions, or unexpected events, also known as black swan events.
Now you have an idea of the parameters you should measure before approaching any stock investment, let’s delve into the key metrics that can separate a winner from a loser.
II. Metrics to consider when selecting stocks
Metrics are criteria that can help you narrow down the list of stocks that are likely to be winners. If applied correctly and consistently, you’ll minimise your risks and boost your return on investment (ROI). In essence, you will protect your capital and give yourself a good chance of growing your investments to complement your income.
Many investors prefer to conduct fundamental analysis by looking at things like annual income statements to understand the financial health of a company or the strength of the market in which a company operates. On the other hand, there are those who look at technical factors such as current market trends to discover the best stocks to buy today.
We have written a guide that details the differences between fundamental and technical analysis; feel free to check it out to bolster your knowledge. Otherwise, for the benefit of both types of investors, here is a breakdown of some of the top metrics from both categories.
For the sake of both types of investor, we’ll look at both fundamental and technical factors.
Fundamental factors are concerned with the stock’s intrinsic value. Essentially, what is the stock’s true value based on its financial performance, assets, and the returns it provides to shareholders?
Fundamental analysts often look at the following factors:
Price-to-earnings ratio (P/E ratio)
P/E ratio is one of the most popular valuation metrics investors look at to determine the relative value of a stock. The metric indicates whether a stock is overvalued or undervalued, and it determines the market value of a stock in relation to the company’s earnings.
You can calculate a stock’s P/E ratio by dividing the market price by its earnings per share. Alternatively, you can divide a stock’s market cap (the combined value of every company share in circulation) by its total reported earnings to achieve the same result.
As a rule of thumb, stocks that have P/E ratios lower than 15 are considered undervalued stocks. On the other hand, equities that have P/E ratios that are higher than 20 are considered overvalued, or growth stocks. Check out our in-depth lesson on P/E for more information.
Price-to-sales ratio (P/S ratio)
P/S ratio demonstrates how much the market values every dollar of a company’s sales. It is calculated by dividing a company’s market cap by its total sales or revenue over the past 12 months.
Calculating a company’s price-to-sales ratio can be especially useful when it has negative earnings. This is because P/E ratios are inconclusive in these circumstances, so calculating the P/S ratio can give you a clear comparison of different companies in the same industry with negative earnings.
Debt-to-equity ratio (D/E ratio)
Debt can spur a company’s growth by providing the much-needed capital to boost expansion efforts. However, too much debt can also be the source of a company’s downfall. Therefore, be sure to look at this metric before you consider buying the stock of any company because it will help you get a glimpse of the overall health of the business.
The debt-to-equity ratio can be calculated using a company’s balance sheet. It’s simply debt divided by equity (the amount of a company owned by shareholders in monetary terms). A high number relative to other companies in the same industry can be considered a red flag since it often signifies the company’s reliance on debt to finance operations.
Sales growth rate
A company’s sales growth rate over a period of three to five years gives you a very good idea of whether there’s a growing demand for the company’s product or service. You should be wary if the company’s growth rate is dwindling, especially when the economy is booming.
If a company has a strong sales growth rate, this is often a small-cap company that is offering a new product or service – or even a technological innovation – to an unserved market. For example, cannabis stocks spent several years soaring in value. A high sales rate generally correlates with a high P/E ratio.
By contrast, a poor sales growth ratio could indicate two different things. Firstly, it could be a red flag that a company is becoming stagnant and may go out of business if it is unable to adapt. Secondly, it could be the result of a large, well-established business that has already captured most of its market share in an industry that is well catered for.
Other than these key metrics of interest, there are many more including return on equity (ROE), free cash flow (FCF), payout ratio, dividend yield, PEG ratio, etc. You can complete our long-term stock investing course for a full rundown.
It is important to remember that each one of these fundamental metrics should not be interpreted on a standalone basis. It is important to take a holistic approach by appreciating each metric in context with the others. A true stock winner is likely to have strong figures across multiple categories rather than a single positive anomaly.
Now that we’ve covered the fundamentals, let’s move our focus over to the technical side of things.
Technical factors reflect investor sentiment with respect to a given stock. The stock is considered bullish when the price is going up and investor sentiment is positive. On the other hand, the stock is bearish when the price is going down and the sentiment is negative.
Here are some important metrics to consider when looking at a stock from the perspective of a technical analyst:
There are three trends in technical analysis:
- Uptrend – The stock is bullish and investors keep buying it because they expect the price to continue increasing.
- Downtrend – The stock is bearish and investors want to sell because they fear that the price will continue to fall.
- Sideways – The stock is neither in an uptrend or downtrend. It is trading within a clearly defined price range.
Before you buy a stock, you must first determine its current trend. Often, the trend dictates the price of an equity regardless of its fundamental value, and this is also true for stock market indices. Experts use indices (indexes) as a measuring stick to determine a specific market’s overall trend.
This is because in a market downtrend, even a good, huge company like Apple or Amazon could lose value, whereas in an uptrend, smaller and less robust stocks may generate greater returns purely because of the broader economic circumstances. This makes downtrends difficult to derive profit from for unseasoned stock market speculators.
If you’re a beginner, aim to buy stocks that are in an uptrend. If you have some experience, perhaps you can also bet on equities that are trading sideways, but we recommend steering clear of downtrends unless you have a very good reason for investing in a stock, or if you are shorting a stock in the belief it will fall in value.
Volume is the number of shares that have been bought and sold in a given time period. You often see volume bars at the bottom of a trading chart that details the price performance of a stock. As a metric, volume indicates how much interest and popularity a stock is generating and is generally calculated daily, weekly, or monthly.
A winning stock is likely to have heavy volume because this means it is highly liquid and is attracting plenty of interest from investors. As a general rule, high volume is usually a positive thing, and the higher the better. Moreover, price often correlates with it, so this is definitely something to look out for.
In addition, if you plan on eventually selling your shareholdings, high volume means finding a buyer should be straightforward.
Volatility is a measure of risk, and it is important when selecting a stock because it represents how dramatically a stock’s price can change at a rapid pace. Volatility is often referred to as standard deviation or how much in percentage terms a stock’s price swings, whether up or down, within a given time period.
For example, a stock that usually moves less than 1 per cent per day is considered non-volatile. By contrast, securities like penny stocks often move up or down by more than 10 to 20 per cent in a single day. As a result, they are considered to be extremely volatile.
For beginners, we recommend staying away from volatile stocks. Distancing yourself from emotional, impulsive decision-making is especially difficult when you are first starting out, and such dramatic price swings can encourage rash or panicked behaviour.
III. Why fundamental analysis is important when buying a stock
It is important because when you invest in something on the basis of its fundamentals, you have a clearer, more objective idea of its true value and potential as a business. This means you can avoid picking stock losers and instead pick up stocks that are trading below their fair value with foolproof business models and solid financial records.
The fundamental metrics that we outlined above – such as the P/E ratio – can help you determine whether a stock is trading below or above its intrinsic value. Those who purchase stocks they feel are undervalued are known as value investors, while those who identify metrics that indicate strong growth potential are growth investors.
Value investors focus on finding stocks that have low P/E ratios with stable earnings, and they have a particular affinity for dividend stocks that produce steady, consistent returns. In comparison, growth investors aim to find stocks with high P/E ratios and rapidly growing revenue.
IV. Why technical analysis is important when buying a stock
While fundamental analysis is important to understand the true value of a stock, technical analysis is important to understand what the market is willing to pay for it. There is a clear disconnect between the market and reality at times, and even stocks with great fundamentals may struggle to grow in certain market conditions. Conducting fundamental analysis may lead you towards a strong company, but technical analysis will lead you towards a strong market.
Being able to accurately predict overall market trends could enable you to grow your capital over time, and it will better prepare you for shifts in the economic environment. Technical analysis provides a clear picture of these trends, enabling you to produce reliable price forecasts based on historical price action and contemporary sentiment.
Technical analysis is as it says on the tin: it is technical. To do it effectively, you need to master the art of reading charts and examining things such as support and resistance levels, candlesticks, and trading patterns. These measurements help provide a clearer picture of the market and are the building blocks of any trend.
V. The bottom line
Now that we have covered the key things that will help you choose a stock winner, we will end this guide with an especially relevant quotation from legendary investor and popular magnate, Warren Buffet: “The stock market is a device for transferring money from the impatient to the patient.”
If you can exercise the patience needed to carry out the necessary amount of self-reflection and analysis, this equips you with the knowledge you need to make money from the market while other less patient investors flounder.
Fact-checking & references
Our editors fact-check all content to ensure compliance with our strict editorial policy. The information in this article is supported by the following reliable sources.
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