How to pick shares: The key elements investors should consider

Increasing numbers of DIY investors are deciding to buy individual shares in their SIPPs and ISAs to grow their wealth, and well they might given the hugely democratising influence of the internet. 

Information on companies has never been as easily accessible as it is today, which makes the job of picking good stocks something private investors can participate in, if they’re willing to put in the elbow grease to thoroughly research their potential purchases. 

But what are the metrics and resources investors should turn to when selecting investments?

Retail investors must consider a range of metrics before selecting a stock to invest in

Probably the biggest store of valuable information for investors lies in the results and reports presented by companies to the stock market. 

Institutional investors have no special treatment compared to private investors here; the results are delivered to the market as a whole at the same time, and for UK stocks can be found on the London Stock Exchange website at 7am each day, or on companies’ investor relations websites. 

These reports are a treasure trove of information. Laith Khalaf, financial analyst at investment platform AJ Bell, picks some key things to look out for.

Earnings Per Share

One of the most important figures in company results is the Earnings Per Share (EPS) figure. This tells investors what profits the company is making for each share they hold. 

There are two main ways to look at this figure. First, consider how it compares with prior periods to see if earnings are heading in the right direction, taking into account any one-off boosts or dents in profits that aren’t repeatable. 

The Chief Executive’s commentary which goes along with the results should alert you to such factors, particularly the ‘outlook’, which looks ahead to the following year. 

Second, divide the share price by the Earnings Per Share figure to derive the Price Earnings ratio, which is a measure of how expensive the shares are compared to the profits the company generates. Make sure you only use the annual Earnings Per Share figure in this calculation – you will get a wonky ratio if you use the earnings from a half year report because you’re only looking at part of the picture. 

Alternatively, you can also get the Price Earnings ratio from other sources such as the websites of some investment platforms, brokers and media outlets. You might be willing to invest in companies with higher Price Earnings ratios if you think there are good prospects for those earnings to grow quickly.

Dividends

The dividend is another key figure in the reports and accounts for investors to mull, especially income seekers. Again, it’s a good idea to compare it with previous periods to see if the income payment to shareholders is growing. 

It’s also worth comparing the dividend per share to the earnings per share and considering how big a proportion of profits are being paid out as dividends. If it’s a high percentage, it may be a sign that dividend growth is likely to be limited, or in extreme cases that the dividend is unsustainable. 

You can also divide the dividend per share by the share price to derive the stock’s historic yield, which again is available on many investment websites free of charge.

Of course, there are some companies which don’t pay a dividend, preferring instead to reinvest profits in the business, and here this measure can’t be used. Big tech companies like Amazon and Alphabet are renowned for this growth-hungry approach which shuns dividends.

Profit margins

It’s worth also looking at a firm’s profit margin. Usually this will be presented in the results, and it tells you what percentage of revenues flows through into profits, which ultimately determine a company’s performance. 

A low profit margin means a company has little room for error or misfortune before slipping into the red, while a larger margin means the company is better placed to weather any storms while still turning a profit. 

Bear in mind some industries simply have low margins, for instance supermarkets and construction. While it may be less of an issue for the former as consumer demand for groceries is relatively stable, construction projects can often run late or over budget, wiping out profits and leading to losses – precisely what happened to Carillion before it collapsed.

Debt

Investors should also pay heed to how much debt a company is carrying. In annual results, net debt is the key figure here. Again you can compare with previous periods to see if it’s heading in the wrong direction, which could be a warning sign. 

You can also divide net debt by EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation) as this figure is often provided in the results. 

This ratio gives an indication of how many years it would take a company to pay off all its debt at current levels of profitability. Generally a Net Debt to EBITDA ratio of less than 2 is considered healthy, and a ratio above 3 starts to raise eyebrows.

Broker forecasts and ratings

There are plenty of other measures to look for in the results too, if you really want to roll your sleeves up, and also other resources you can use outside company reports which might help. 

Laith Khalaf: Investors should give thought to portfolio diversification 

For instance, on their investor relations websites, many large companies will provide the average of professional analysts’ estimates of earnings in the forthcoming year (known as the consensus estimate). This can give you an idea of market expectations for a stock, and in the short term, share price movements will be guided by how actual performance measures up to these forecasts. 

Broker ratings are also available on many websites, which tell you whether analysts rate a company as a buy, hold or sell. 

These don’t tend to be very useful however, as there are usually as many saying sell as there are hold or buy. And when there is clear analyst agreement on a stock, that’s usually baked into the price. 

Overall you might want to look at analyst ratings and estimates to get an idea of how the market views a stock, but it shouldn’t play a major part in your investment decision. Analysts tend to focus heavily on the next twelve months, whereas investors should be thinking about becoming an owner of a company for five to ten years or more.

Portfolio diversification

As well as picking good companies to hold for the long term, investors should of course give some thought to portfolio diversification. If all the companies you select are in the same country, or in the same industry, then your portfolio will be extremely vulnerable to a downturn in those areas. So make sure you’ve got a good spread of investments. 

You should also make sure there are enough companies in your portfolio to minimise the impact of one performing particularly poorly, or worse still, going bust. 

As a rule of thumb, the professional fund managers with the most concentrated portfolios still have around 30 stocks in there. That probably sounds like quite a lot for most private investors, particularly seeing as you need to regularly review your holdings as well as picking them in the first place.