How to choose which shares to buy

How to choose which shares to buy

Choosing which shares to buy can be nerve-racking. There are many options and variables to take into account. Here we look at a few of the key attributes for investors to consider when deciding which shares to buy. 

This list is not exhaustive, and individual investment styles will emphasise different attributes. Nonetheless, it’s a handy starting point for anyone wanting to navigate the share investment world successfully. 

How each person invests will depend on their personal goals, risk profile, and time horizon. This means that individual investors will seek investments with different attributes. Some investors may look for capital growth, while others are chasing an income stream. Whatever you want to achieve, it is worth considering the questions below and how they apply to your investments.

Is the company growing its earnings?

Growth in company earnings is one of the most important factors to consider when choosing which shares to buy. Company earnings represent net profit, which is the income earned by a business minus running costs. Earnings growth is a good indication of a healthy and profitable business. 

We can distinguish earnings from revenue, as revenue growth indicates increasing sales. While this is usually a positive, if expenses are also increasing, earnings can suffer. Earnings take account of the costs of running the business, so they are a better indicator of overall profitability. 

When you buy a share, you are purchasing part ownership of a company. This gives you the right to share in the future profits of the company. If earnings are growing, returns to shareholders should increase in the long term. 

Earnings growth is often reflected in a rising share price. The price of a share in part reflects the current value of future cash flows accruing to the shareholder. If earnings are growing, shareholders should be in line for more significant cash flows. This, in turn, means the share is likely to be valued more highly.  

Is the company generating cash?

A business needs cash to survive and thrive. Cash flow refers to the inflow and outflow of money. Funds flow in as revenue and out as expenses. 

Positive cash flow indicates a company has money left over after paying its expenses. This is a good sign, as it allows the business to invest in new opportunities and even return money to shareholders. Negative cash flow indicates the liquid assets of the business are being eroded. This could be cause for caution, as a business will be considered insolvent if it lacks the capacity to pay its debts.  

Cash flow differs from earnings or profits. A business could record profits but still have trouble paying its debts if money is tied up in illiquid assets or accounts owing. Alternatively, a business could see strong cash flow, but no corresponding increase in profits if expenses rise or it has large debts to service. 

This means it’s important that investors monitor both cash flow and earnings. Cash flow is what allows companies to manage their debt, invest in growth, and pay dividends. Companies may be able to borrow or raise capital to fill short-term gaps in cash flow, but they cannot survive with insufficient cash flows forever. 

How much debt does the company have?

Debt can be a good source of capital to fund growth, but too much debt can quickly become crippling if things don’t go to plan. Debt financing allows businesses to leverage small amounts of money into much larger sums, which can enable rapid growth. Interest payments are also generally tax deductible. 

But companies that carry debt need to generate cash to service that debt. Interest payments must be made regardless of the company’s actual cash flow. This can be risky for businesses with inconsistent cash flow. 

A company carrying a large amount of debt may have less ability to withstand a downturn than a company with less debt. This is because interest payments will have to be made even if revenues or cash flows decline. Where a company carries debt, it must be able to service that debt.

What is the share’s P/E ratio?

A share’s price-to-earnings (P/E) ratio is its share price divided by its earnings. The P/E ratio is used to measure the relative value of the shares. At a basic level, the P/E ratio reveals the price the market is currently prepared to pay for the earnings of a particular company. 

This can be used to compare different companies in the same industry. For example, if Coles Group Ltd (ASX: COL) had a P/E ratio of 21 and Woolworths Group Ltd (ASX: WOW) had a P/E ratio of 29, Coles would be ‘cheaper’. This is because you have to pay less for each dollar of Coles earnings than for each dollar of Woolworths earnings. 

But the ratio has its limitations – it doesn’t work well for newer companies and those not yet generating earnings. Companies with high P/E ratios tend to be companies that investors expect to grow their earnings in the future., Inc (NASDAQ: AMZN) is a classic example – it has traded at a P/E ratio above 1,000 in the past. 

What is management’s track record?

A company is, at its core, a bunch of individuals working towards a common goal. This means that management has a strong ability to influence future direction and profitability. The quality of a management team is, therefore, an important consideration for investors. 

Leadership value can be difficult to evaluate given its intangible nature, but it is worth investigating. Management makes strategic decisions and is in charge of creating value for shareholders. Many investors like management to have ‘skin in the game’ in the form of equity interests in the company. This can help align management interests with those of shareholders. 

Where possible, it can help to examine management’s record of returns. One way to do this is to calculate the return on investment of a manager or management team. Return on investment is a profitability ratio that calculates the return an investment generates relative to its cost. 

Management at Amazon has been able to generate consistently strong returns on investment operating under a compensation system that closely aligns its interests with those of shareholders. Bonuses are paid exclusively in equity, which generally has a longer than usual vesting period. Similarly, the company has opted to reinvest earnings at a high rate of return, increasing overall shareholder value. 

Does the company have industry tailwinds or headwinds?

If you're investing for the long term, it’s worth taking a broader view of your potential investments. You’ll need to consider the future prospects of the industries in which they operate. Is the industry growing or shrinking? Is your potential investment an innovator and market leader, or subject to strong competitive forces? 

These factors will all help shape the future performance of your investment. Companies operating in growing industries are more likely to experience growth-related tailwinds that will boost earnings over the long term. Those in shrinking industries must scramble for market share to grow.  

Companies can also benefit from internal tailwinds, such as a future-proofed culture. Innovative companies that are leaders in their markets tend to benefit from barriers to competition that enhance performance over the long term. 

Headwinds, on the other hand, provide barriers that companies must overcome on the path to profitability. Regardless of your investment goals, it is worth considering these factors when making investment decisions. This will help you make an informed assessment of future performance prospects.

Article last updated on 23 March 2022. John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Motley Fool contributor Katherine O'Brien owns Amazon. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns and has recommended Amazon. The Motley Fool Australia owns and has recommended COLESGROUP DEF SET. The Motley Fool Australia has recommended Amazon. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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