How to pick a stock

There are more than 1,500 shares listed in the UK alone and tens of thousands across the globe which gives investors a huge amount of choice over what companies to invest in.

Narrowing down the field requires some research to determine if a stock fits with your preferences and investment goals.

While everyone is different, there are some broad principles which can help you and we’ll explore them in this article.

First, if you’re investing in individual company shares you should only invest in your very best ideas. Quite often investors spread their money across tens or even hundreds of different stocks which is far too many to be manageable. To achieve this level of diversification you’d be better off simply buying a fund and you’d save in dealing charges too.

Become a part owner of a business you understand

You should also train yourself to think in terms of being a part owner as well as an investor. After all, if you buy shares in a company, you are literally buying a share in the company’s business.

For that investment, you may be entitled to part of the company’s future income and profits in the form of dividends. You also hopefully benefit from your shares going up in value if the business is successful. Approaching stock picking this way helps ground your decisions and avoid the trap of seeing your investments as simply numbers on a screen.

And, while you don’t, for example, need to be a technology expert to invest in a technology stock, you do at least need to have a decent understanding of the business in which you are buying shares and what it does. If you don’t then you shouldn’t invest in it.

How is the business performing and does it have a strong balance sheet?

Assuming you do have a reasonable handle on a company and its operations then you need to look at how it is performing. The latest set of results are a good starting point and this video series from AJ Bell's Investment Director Russ Mould has some extremely useful pointers on how to read a set of company accounts.

An individual set of results is just a snapshot; you need to look at how a company has been performing over the longer term to get a true sense of its merits as an investment. It is also important that you remember to look at cash flow and the balance sheet rather than just revenue and profit.

Markets are forward looking so having data on what analysts are forecasting for future revenue and earnings is useful. There are free sources of this information online as well as paid-for services. You can get some forward-looking metrics on our website.

What about the valuation?

Using this data, you can then look at valuation. The price to earnings ratio, or PE for short, is a good starting point thanks to its simplicity. Calculated by dividing the share price by earnings per share, it can give you a feel for how a stock is valued by investors.

In isolation this number might not mean much, but by comparing an individual company PE to those of its immediate rivals, to its long-term average and to the wider stock market you can get a sense of whether a company has a premium or discounted valuation.

Should you buy on a dip?

If a stock looks expensive based on valuation metrics but the business has a great long-term track record, a good idea could be to wait until there is a broad market sell-off and to use that as an opportunity buy at a more attractive price. Or, if a company is going through a temporary rough patch which has knocked the share price, but you can satisfy yourself that this is down to one-off factors, you could look to play a potential recovery. It might be useful to have an idea in your head of a valuation or share price that you would be willing to buy at or even set a limit order to do this when a stock hits a specified level.

The PE ratio undoubtedly has some limitations, it does not for example factor in borrowings, but there is nothing to stop you using it as a way of filtering potential ideas and then examining things like how much debt a company has or how fast its earnings are growing to help build up a fuller picture of the investment case.

What catalysts are there to move the share price?

Even if a company is trading at what appears to be a discounted valuation, it can stay that way for a long time without a catalyst which can unlock this value. Identifying potential catalysts can therefore be an important consideration when determining which stocks to buy.

These might be a contract win, directors buying or selling shares or a major restructuring effort. Aircraft engine maker Rolls-Royce shows how powerful a recovery story can be, the shares increasing more than 10-fold since Tufan Erginbilgiç took charge at the start of 2023 with a plan to turn around its fortunes.

The most obvious regular catalysts are updates on financial performance. This includes full-year, half-year results or quarterly results. Their ability to move a share price is typically determined by the outlook statement and whether the numbers are ahead of or behind market expectations.

Most companies will also update on trading in between their published results. This encompasses both scheduled trading statements and unscheduled ones either warning on profit or upgrading guidance.

Should you consider overseas stocks?

There is no reason you should necessarily restrict your choice to UK stocks, particularly given its limited footprint in certain sectors. Most platforms allow you to trade a range of major global markets. However, if you are investing abroad, it is worth thinking about any necessary paperwork and any additional costs you might incur. Find out more about international investing.