Stock Market Trading

How to Identify Companies with Good Potential

It is every investor’s dream to make full profit from the various investments that they have put money into. However, in reality, it is an ongoing challenge and effort to ensure that your investments give you positive returns. Many investors take it for granted when they invest in companies with good profiles and are taken aback when their investments fail. At the end of this article, you will be able to identify some of the traits of companies with good potentials and how to match it to your investment objective and risk profile.

Typical Investor Behaviour

So why do most investors fall short even when investing in good companies? Looking at the market behaviour, we will notice that many investors’ decisions are influenced by relatives and friends around them. Be it through rumours, hearsay or tips, these are the usual basis of investment decision making instead of proper research as most of them are inclined to invest in “hot” or “in” stocks. They enter the market during a very bullish period, when the market is almost at its peak and get caught in a situation of ‘buy high, sell low’. When a stock is seen continually going up, investors think ‘buy’ and when they see a stock going down, they think ‘sell’.

Hence, an investor needs to sharpen their skills of finding gems in the stock market. They need to be able to identify companies with good potentials but have yet to be discovered by the market.

Cheapness – ‘Buy low, sell high’

Logically, in order to make money, investors will have to ‘buy low, sell high’ but this is easier said than done. Usually, by the time we hear that a particular stock is good, the rest of the world seems to have been clued in and the price of that stock would already been too high for us to profit from.

To know whether a stock is still worthwhile for us to invest, the common financial indicators being used are the price ratios:

  • price/earnings ratio (P/E)
  • price/sales ratio (P/S)
  • price/book ratio (P/B)

A low price ratio basically indicates that the price is still relatively lower as compared to its fundamental value, which is being represented by its earnings, sales or book value. However, when using these ratios, investors have to be more cautious as sometimes, these accounting figures could be misleading.

To overcome accounting flaw, some investment gurus suggest that we should also look at the cash flow, which are less prone to accounting gimmicks. The most commonly used financial indicator is the earnings before interest, tax, depreciation and amortization (EBITDA), which is the earnings after taking away the non-cash items and taxes. This represents how much the company is actually generating from its operations after netting off the operating expenses.

Analyzing a company’s weakness

Sometimes, a company might seem that it is undergoing a downward spiral, but an investor has to be smart and analyze how badly that weakness will affect the company’s growth potential. For example, when a company’s price is temporarily being depressed due to lower than expected earnings or cyclical impact that will eventually recover, buying these stocks while it is being neglected by the market will enable us to profit when the price recovers. However, there are times when a stock price may be low for a good reason. Therefore, investors need to read into the details of the company financial reports and pay attention to the information or news about the company to make sure that the company is still fundamentally strong and has high potential of becoming market favourite again in the near future.

Growth possibilities

Besides the cheapness of a stock, investors may also look at the growth possibilities of a particular stock. In order to discover the future growth prospect, investors need to do further research on the overall business environment to judge whether the company is in an industry that is having growth opportunities. From the company’s perspective, the growth opportunities may come from a product or service that will potentially be a hit in the market. Similarly, the company could also be in the process of developing a certain technology or medicine that is expected to have a huge demand or create a new trend. These types of potential high growth companies are usually found in the emerging technology or medical company that are heavily involved in research. However, investors must also be careful as the risk of investing in these types of companies may be high in the event that the intended product is not a success.

 

In addition, we may also study the business environment to discover potential growth opportunities. For example, if the government is pushing for development in certain industries or projects, the stock prices of companies that are going to be involved will most likely be in the uptrend in the near future. Investors need to make use of the publicly available information to draw wise conclusions on the potential candidates which are going to benefit from the development. In finance terms, this is called making our ‘mosaic theory’.

Investors may choose to focus on uncovering the potential value of the stocks, looking for growth opportunities or combining both. However, as we can see, in the process of identifying stocks with good potentials, it also comes with higher risks. Therefore, investors must always invest in line with their risk profile.