How to pick great stocks: complete guidance!

Today, I will show you how my stock selection process looks and what steps you need to go through in order to pick great shares. Before we start, I need to tell you that there is no secret formula for picking stocks that will always be rising or companies that will always be great. There is no formula that always works and leads to always winning stock selection, which is the reason why market risk is sometimes called uncontrollable risk because we never know what will happen with the company in the future, and a great stock today may become an absolute disaster in a few years. But you may ask, "If we can't pick stocks that will always be rising or companies that will succeed in the longer term, why do we need this guidance?" This is a good question. You need the guidance to increase your chances of picking tomorrow's success stocks that will bring you good profits and companies that may prosper in the nearest future. Today, I will show you several steps that you need to take to make sure you are better off than 95% of traders who choose stocks only based on stock price levels and have a higher chance of losing money over the longer term, but you have more chances to win since I will walk you through this great guidance that will help you understand the company and manage your risk better. So let's start.

Stock selection process explained.

First, I start with gathering company information. I am trying to understand the company's product or service and who are its closest competitors and what market shares they have. I need to know what the company's product is about, and I have to believe in their future. For example, if you are a developer and build applications, you can use Google's Firebase for storing your data, which saves your time and you can avoid learning backend. You already have one advantage of Google's services over competitors. You can also use Google AdSense or AdMob for showing ads on your app, and it is all can be set from one place. You can go further and analyze Google's clients that post ads on Google. For example, large institutional players who issued an ETF that tracks bitcoin use Google for advertising their product. You already see strong support from Google shares. If you are an iOS developer, you can use Apple's services. You know that developers pay $100 yearly subscription to be featured on the App Store, and the number of iOS developers is raising every year, and now Apple makes its main focus on its services as hardware sales are declining. If you analyze what is the growth rate of developers on a platform, you can see if the rising App Store popularity can cover declining sales and tell if this will create support for Apple shares over the longer term. By gathering company information, I try to understand what is the company's growth potential and if the company still has space for growth or maybe their smaller competitors with more interesting products can take the market share from larger companies.

Using financial ratios

My second step is to use financial ratios to understand if the company looks strong in comparison to its closest peers. If in the first step we did not touch the numbers much, in the second step we take a closer look at the numbers and do quantitative analysis. I have already explained what are the most useful financial ratios for evaluating companies quickly and finding great stocks among closest peers. I was talking about WACC and ROIC ratios, the analysis of those ratios gives a great picture of how efficiently the company uses its attracted funds. Investment analysts also use basic ratios such as P/E or P/S ratios to see how much traders are willing to pay for the company's earnings and sales and conclude if the company is overvalued. Evaluate companies' liquidity using liquidity ratios. These measure the company's ability to meet its obligations. Examples include the current ratio and quick ratio. Also have a look at profitability ratios. These measure the company's ability to generate profits. Examples include the gross profit margin, operating profit margin, and net profit margin. You can read about other useful financial ratios. You should compare your selected company's ratios to the closest peers. If you don't know the company's peers, you can use Financial Modeling Prep's peers API. If the company looks better than its peers, then I proceed to step 3. If I found a better company among closest peers, I start with step 1 and analyze a new company that looks better than my initially analyzed company.

Analyzing financial statements

Step three, analyzing financial statements. Gather the company's financial statements, balance sheet statement, income statement, and cash flow statement. You can use Financial Modeling Prep's balance sheet statement API, income statement API, and cash flow statement API to get that information. After you extracted the company's financial information, perform vertical and horizontal analysis.

Horizontal analysis involves comparing the company's financial performance over time. Calculate the percentage change in each line item on the financial statements from one period to the next. For example, you may calculate the percentage change in revenue, net income, or cash flow from operations. This will help you identify trends and assess the company's growth trajectory.

Vertical analysis involves comparing each line item on the financial statements to a base figure within the same period. For example, you may calculate the percentage of total assets that is made up of cash, or the percentage of revenue that is spent on cost of goods sold. This helps understand the company's financial structure and how it allocates its resources.

Your chosen company should have consistent growth when it comes to revenue or net income, stable data when it comes to growth margin, same or declining costs. Large changes in the company's financial statements are like a warning sign and should be analyzed carefully. For example, if you see that costs increased several times from the previous quarter, you should dive deeper to understand what was happening. You can read the auditor's report in the company's published income statement to understand what was the cause for the cost increase.

Calculate stock fair value

If the company looks strong, has leading positions or is gaining market share quickly, if it has great financials in comparison to closest peers and shows great growth and stability, you can jump to the next step. Equity valuation. I can use different valuation models to calculate the stock's target price. This is a fair value of the stock price based on analysts' forecasts. You can use the Discounted Cash Flow Model, or Dividend Discount Model if the company is paying dividends, or a financial ratios model that is using financial ratios to compare the company to closest peers. If the stock's target price is at least 10% higher than the market price, it's a good sign for me, and the stock is undervalued. If it is 30% for example, the stock has great growth potential, based on your custom assumptions that you put inside your valuation model.

Calculate your expected losses

Next step is to understand your risk level. For that, I can use the Value-At-Risk model (VAR), to calculate the highest possible loss with high confidence. VAR can be calculated both for a single stock and for the investment portfolio. I also use Monte Carlo simulation model to understand what is the probability my loss/gain would exceed 5%, 10%, or 20% for example. You can use this model to make general approximation of where your income/loss can be based on the simulation that I run in Excel. If I like what I see and the stock is not very risky, I can proceed to the next step, or I start again and choose another company from the closest peers.

Build an efficient investment portfolio

My last step includes seeing how my stock would behave in the investment portfolio, and what should be the percentage of the stock in my portfolio to get the lowest possible loss under my identified expected return. To do this, I use the Markowitz model and build an efficient portfolio. This model tells me what should be the percentage of my selected stock in the portfolio to make it efficient.

I hope you learned a lot from this guidance. Now you know how to choose stocks, analyze them, calculate fair value, and manage your risk properly. You also know how to balance your stock in the investment portfolio. Don't forget to regularly check your stock, and you may consider replacing it if it becomes more volatile, if the company financials worsened, if your investment goals have changed, or if your portfolio is not efficient anymore.