Being good at stock and ETF picking is an extremely important financial skill that will allow you to maximize your investing returns and minimize your risk.

This post should help you understand the most important factors of companies and funds to consider when you’re evaluating whether or not to invest in them.

Invest don’t gamble

If you don’t understand a companies strategy, financial fundamentals, or what products or services it’s selling, you have no way of accurately predicting if it will succeed. Essentially, if you don’t understand the companies you’re “investing” in, you’re just gambling that it will succeed. That’s why it’s so crucial to at least broadly understand a company.

Product

Start by researching it’s a product to understand what the company does. The information you find may be confusing and filled with jargon you don’t understand. In that case, it will be difficult to correctly evaluate its risks and opportunities, meaning you probably shouldn’t invest in the company.

Balance sheet

Next, look into its core financials like its revenues, margins, cash on hand, growth patterns, etc. This will give you an idea of the size, maturity, and growth rate of the company.

Interviews

You can also watch interviews to understand a company and its leadership even better. Often, interviewers ask incredibly insightful questions that dig into a companies core value proposition (the value it provides) to help you build confidence as an investor.

Criticism

Similarly, watching commentary and criticism of a company on YouTube can help you understand a company’s risks and look at it through a more realistic lens. However, sometimes videos present false or misleading information, so make sure to fact-check it.

Growth Potential 

Future growth potential is the most important factor when evaluating a companies stock, which is what all the elements described in this post try to help you evaluate. 

There are four things to consider to evaluate a companies growth potential. Is the company in a growing sector? Is it gaining market share in its sector? Is it selling new products? Or is it increasing its margins? The answer to at least one of the questions should be yes.

For example, the EV vehicle manufacturer Tesla, a part of the rapidly growing EV sector, consistently increases its sales and expanding its product line. Tesla has a ridiculously high valuation compared to its earnings (P/E ratio) because its future growth potential is a significant factor in its current valuation.

It’s also imperative to find companies that will grow for many years in the future, and not just in the short term. It should be providing a product or service that will be useful decades into the future, not just the past or present.

Taking into account all these factors should good idea of a company’s future growth potential. However, considering growth potential alone won’t give an accurate picture of a company. There are many other risks, criteria, and advantages to consider to build a thorough understanding of a company.

Proof of concept/demand

When you invest in a public company, it should always have a proof of concept, demonstrating that it can effectively produce and sell its product.

Many companies (especially SPACs) are “idea companies” that only have a prototype or have little to no proven demand. Having no proven demand or no product makes that company extremely risky because of the almost infant problems they could encounter bringing a product to market and selling it in significant quantities.

Although this doesn’t mean the company is bad, rather, that you should wait a few years for it to mature before investing in it.

Instead, buy stocks of companies that already have created a scalable solution to a large problem. They should already have started producing a product, have demonstrated significant demand, and are currently mass-producing it or have a clear path to mass production.

PE ratios

“The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings (EPS). The price-to-earnings ratio is also sometimes known as the price multiple or the earnings multiple” – Investopedia. 

“The P/E ratio helps investors determine the market value of a stock as compared to the company’s earnings. In short, the P/E shows what the market is willing to pay today for a stock based on its past or future earnings” – Investopedia.

The types of P/E ratios:

There are two types of P/E ratios, forward and trailing. A trailing P/E ratio is a company’s price per share divided by its earnings per share for the past 12 months. In contrast, a company’s forward P/E ratio is calculated as its price per share divided by its projected earnings per share for the next 12 months.

How to use P/E ratios:

Currently, the average trailing P/E ratio of the S&P 500 (a popular stock market index) is ~45.45, while the forward PE ratio is only ~23.12. This means that analysts expect earnings to increase significantly over the next 12 months. 

However, where P/E ratios are much more helpful is with individual companies. For example, Square, a financial services and digital payment processing company, has an extremely high trailing P/E ratio (even for a tech company) of approximately 450. Investors who buy Square now, while it has a P/E ratio of ~450, are willing to pay much more than the company’s worth right now, with the hopes of benefiting from significant future growth.

On the other hand, some companies have a lower trailing P/E ratio than their forward P/E ratio, signaling that they might currently be undervalued.

Competitive advantage

Any company you invest in must have an advantage that sets it apart from its competition (if it has any). Whether it’s a cheaper or all-around better product, there has to be something that protects the company from its competition.

Better product 

This factor should be self-explanatory; if a company has a better or cheaper product than its competitors, it has a huge advantage. In the end, the company with the best product almost always wins.

Loyal following

Having a loyal following of customers is extremely valuable. Part of what makes companies like Starbucks so valuable is their following of customers who religiously go there every day, creating a reliable income source for the company.

Network

Facebook (who also owns Instagram) is one of the world’s largest companies, but it isn’t that unique. It would be easy for someone to create an exact copy of Facebook. So why is it so valuable? Because of its network of literally billions of active users. All of its users can communicate in one place, which can be easily monetized by serving ads generating billions in revenue. Even if someone tried to copy Facebook, it would be worth nothing without its user network.   

Network and Reputation

Another important factor to consider is a company’s name recognition and reputation. Having good reviews, customer services, and an easily usable product or interface shows that the company cares about its customer, help it build a loyal following of dedicated customers. 

Name recognition

Almost everyone’s heard of companies like Starbucks, combined with their seemingly endless number of locations, makes it easy for them to get customers and build a loyal following. However, companies that may have similar (if not better) coffee than Starbucks have absolutely no brand recognition and only a few locations. This means they would have to spend significantly more to acquire each loyal customer.

Reputation

Having a good reputation is another important factor in a companies success. Consider these five factors to evaluate if a company has a good reputation and is trustworthy.

1. Reviews

Having good reviews is a direct indication of customer satisfaction and can tell you a lot about the company’s strengths and weaknesses.

2. Customer service

Companies having good customer service (helpful, fast response times, etc.) shows that the company cares about its customers, creating a good experience for them that helps to build a loyal following.

3. User experience

Having a well-designed app or website also facilitates a good user experience. If people enjoy using a companies app or website, they’re likely to continue using their services. In contrast, if a company has a poor app or website, it will cause its users to have a bad experience and associate the company with confusion and frustration, making it much harder to keep customers. 

4. Practices

A company must have good practices to maintain a good reputation. Consider factors like how much the company pays its workers, if it’s been involved in scandals, faced severe legal allegations, has sustainable practices, etc. 

If a company does have good practices it’s much less likely they’ll get into a situation that negatively affects its business. Additionally, you probably don’t want to invest in companies that treat it’s workers poorly, have wildly harmful practices, or are generally shady. 

5. CEO

A CEO is a direct reflection of a company and its leadership. Consider the following questions: Is the companies CEO trustworthy? Do they have a strategy you agree with? Are they professional? Do they believe in the company? Hopefully, the answer to all of those questions was “yes” for any companies CEO you’re invested in.

Innovation

Innovation is another factor to consider when you’re evaluating a stock. Often, innovative companies that are inventing new products go for years until it’s profitable. However, innovative and disruptive companies can provide the best return on your investment. 

There are two types of innovative companies to look for:

Disruptive companies

Tesla is an example of a company thats disrupting the automotive industry. Because the little competition Tesla has is years behind the company, many of Tesla’s investors believe it’s poised to be one of the world’s biggest car manufacturers. This is the main reason why Tesla has such a high valuation.

Companies that are disrupting existing industries (or making new ones) have a huge opportunity as a first-mover and a potential to gain significant market share quickly. These factors make disruptive companies an attractive investment opportunity if you can identify them early enough.   

Companies that innovate on existing products 

Apple, the world’s largest company, is in many ways similar to its competitors like Samsung, Microsoft, and HP. But what sets Apple apart is its design. Apple innovated on the phone, computer, headphones, and more, consistently producing beautiful, sleek  products with a simplistic interface, utilizing the latest technology. 

Apple has leverages these distinguishing features to built an extremely loyal fan base of people willing to wait in lines for days to get their latest product, even if it costs much more than it’s worth.

Risks

Always consider the risks to a company’s success before you invest in them. The three biggest factors to consider are production, competition, and lack of demand.

Production

Companies that produce a physical product often face problems when it comes to mass production. If the company isn’t currently mass producing its product, the road to mass production is difficult problem investors should consider. Additionally, once a company starts mass production, any number of things could go wrong; the product isn’t being produced fast enough, there are kinks in the supply chain, difficulty with shipping, etc.

Competition

Competition is usually one of a companies biggest concerns. If a different company comes along with a better or cheaper product than the existing company(s) selling it, the company with the best product will almost always win. 

Demand 

Often, companies have problems with demand. They don’t have enough demand to sustain the company or have too much demand and can’t scale production quickly enough. Additionally, over time some companies become obsolete, disrupted by newer companies, and eventually fade into irrelevance.

Index funds and ETFs

ETFs and index funds are two different investment vehicles that allow you to own a basket of securities under one ticker symbol that you can trade like a stock. 

“An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock” – Investopedia.

“An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index”- Investopedia.

For example, the S&P 500 is an index of the 500 largest US companies. You can invest in the S&P 500 by buying shares of NYSEARCA: SPY, meaning you would own a small portion of every company included in the index.

The advantage of index funds and ETFs

There are a few reasons why you may want to invest in index funds and ETFs. However, their greatest advantage is that they allow you to diversify your portfolio easily. 

“diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.” – investopedia.com 

How to choose the right index funds and ETFs

Another benefit to investing in ETFs is that it’s a lot easy than picking individual stocks. Instead of needing to understand the finances and strategy of a company, when you’re choosing an ETF or index fund, there are much fewer factors to consider.

Index funds and ETFs also take away the need to pick individual stocks. Instead, you can easily invest in a diverse group of companies and feel comfortable knowing that over a long period, it’s very likely that you will make money. However, investing in an index fund may generate lower returns than the more risky strategy of picking individual stock picks. 

The three main factors to consider when you’re choosing what fund to invest in are your time horizon, the expense ratio, and the fund’s theme or strategy. 

Strategy 

A funds strategy is crucial to understand if you’re considering investing in it. Most index funds and ETFs have an explicit theme that all of their assets are related to. 

For example, ARK Genomic Revolution ETF $ARKG is comprised of companies that are “focused on and are expected to substantially benefit from extending and enhancing the quality of human and other life by incorporating technological and scientific developments and advancements in genomics into their business” – ARK Invest. 

Expense ratio 

A funds expense ratio is another important factor to consider. An expense ratio is a fund’s total administrative costs minus its total assets under management. 

For example, a fund with an expense ratio of 0.09% per year would cost you $9 on a $10,000 investment.

Index funds typically have a low expense ratio (often less than 0.10%) because they have low administrative fees as a result of tracking an index. On the other hand, ETFs often have much higher expense ratios because they have to conduct research, hire analysts, decide when to buy and sell, etc. 

The takeaways

1. Invest don’t gamble
2. Understand the company you’re investing in
3. Consider the company’s growth opportunity 
4. Make sure companies you invest in have proved their idea
5. Trailing and forward P/E ratios can be useful to evaluate if a stock is overvalued or undervalued 
6. Companies you invest in should have an advantage over their competitors
7. Consider if the company has innovative technology
8. Evaluate what the risks are to a companies success 
9. Picking index funds and ETFs is simpler than picking individual stocks.
10. Investing in funds allows you to easily diversify