Learning how to search for stocks to invest in includes discovering the best financial ratios to use

Are you interested in how to search for stocks to invest in? In the long run, investors make most of their profits in investments that offer good value and an attractive long-term outlook. Here’s how to find them:

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Take a broad view when you consider how to search for stocks to invest in

When we’re looking for the best investments to recommend in our newsletters and investment services, we start by putting all the important information we know about a company into perspective.

But things are never quite so simple. Your stock pick’s latest earnings may reflect unusually favourable or unfavourable conditions. This can make the company look safer or riskier than it really is. In addition, the company may put the funds it borrowed to immediately profitable use, increasing its earnings and its ability to pay interest. It may plan to sell assets to reduce debt, or cut costs to increase earnings.

In the end, there are many ways to try to put the facts about a company into perspective. None are perfect, since all involve a mental balancing act between high and low estimates, history and the future, and faith versus skepticism.

Our goal is to put the information in a form that lets us weed out the extremes—excessively overvalued stocks, or those that are suspiciously cheap. In the long run, investors make most of their profits in investments that offer good value and an attractive long-term outlook.

Learn how to search for stocks to invest in with the help of these four financial ratios

When you’re looking for undervalued stock picks, as a first step it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele.

High-quality undervalued stock picks like these are rare and hard to find, even when the markets are down. But when you know what to look for, you can discover them. These are four of the financial ratios we use as a guide to spotting undervalued stock picks:

1. Price-earnings ratios: The p/e is the ratio of a stock’s market price to its per-share earnings. There are many exceptions, but as a general rule, the lower the p/e, the better, and generally a p/e of less than 10 represents excellent value.

To determine undervalued stock picks, we calculate the p/e ratio for a stock by using the most recent financial data. But we also analyze the “quality” of the earnings. For instance, we disregard a low p/e ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily bloats the “e.” (That shrinks the p/e.) Similarly, we add back any one-time items, such as gains or losses on asset sales, writeoffs on so on, so we don’t miss out on bargain stocks that would have had low p/e ratios if not for those non-recurring items.

2. Price-to-book-value ratios: The book value per share of a company is the value that the company’s books place on its assets, less all liabilities, divided by the number of shares outstanding. Book value per share gives you a rough idea of the stock’s asset value. Note that this ratio represents a “snapshot” in time, and could change quickly.

3. Debt to equity ratios: This ratio comes in several variations, but the basic idea is that you measure a company’s financial leverage by comparing its debt to its shareholders’ equity. In essence, you assume an attractive company can earn a higher return on its total capital than the interest rate it pays on the debt portion of its capital.

Note that we also look closely at a company’s debt-to-market-cap ratio. (Market cap is the value of all shares the company has outstanding). Debt is usually a hard number. Bonds and other loans generally come with fixed interest rates, fixed terms of repayment and so on. Shareholders’ equity numbers are fuzzier. They mostly reflect asset values as they appear on the balance sheet (minus debt, of course). But the balance-sheet figures may be misleading. They may be too high, if the company’s assets have depreciated since it acquired them (that is, depreciated more than the company’s accounting shows). In that case, the company will eventually have to correct the balance sheet figures by cutting them or “taking a writedown.”

Or, the equity value may be too low if the company’s assets have gained value since the company acquired them. This can happen with real estate and other investments.

4. Price-cash flow ratios: Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays.

Use our Successful Investor philosophy to choose winning stocks

Whether buying stocks without a broker or with, we recommend investors build a portfolio mostly comprised of well-established companies. As well, some of the biggest profits you ever make will come from buying stocks before they find their way into the limelight.

Above all, we recommend using our Successful Investor approach. One key part of our three-part investing program is to diversify: to spread your money out across most, if not all, of the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities. Diversifying your stocks across the five sectors is more than just a safeguard—it will significantly improve your chances of making money.

What tools do you use to search for stocks to buy?

What advice would you share with new investors looking for stocks to invest in?