How To Choose A Stock: A Step-by-Step Guide

By Jeremy Bowman Markets Fool.com

So you're a beginning investor and you want to know how to pick a stock?

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Good news. Even an average stock-picker should get a return around 9% a year, themarket's historical average. Now let's take a look at how you can find the best stock for you.

Step No. 1: Decide what your investing goals are

Different people invest for different reasons. Some are looking to build wealth for a life-changing event down the road like retirement or a child's college fund. Others are looking for an income stream to provide spending money. Some want to speculate for a potential big gain, while others are just looking to preserve the money they already have.

Traditionally, the two opposite ends of the investing-style spectrum are growth and income. Chances are your own investing strategy will fall somewhere on this spectrum. Growth investors tend to target, high-priced stocks, with strong growth rates and lots of potential. Think Amazon.com or Facebook.Income investors, on the other hand, favor slower-growing, stable companies that pay dividends. Coca-Cola andMcDonald's are good examples of top income stocks, often called blue chips.

Your investing goals will likely depend on your own life situation. If you're a young adult looking to save money for retirement or a down payment on your first home, a growth strategy will probably be a better fit. If you're a retiree looking for money to supplement your income, choosing reliable dividend stocks would be better for you.

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Step No. 2: Learn some stock basics

Investing in the stock market can be intimidating for new investors. The stock market is full of confusing jargon, and the risk of losing money is very real. But it's not as complicated as it may seem. You only need to know a few terms in order to get a basic understanding of any stock. Here are three you should know:

  • P/E ratio:The price-to-earnings ratio (P/E ratio) is the best indicator of how expensive a stock is. The actual price of a share, on the other hand, is relatively meaningless. The P/E is simply the price per share divided by earnings per share. It shows much investors are paying for a dollar of profits. Historically, the average P/E ratio is 15.7. Today, the S&P 500 P/E is 26.25.P/E ratios can range from none for companies without profits, to the triple digits for companies with slim profits and high prices, and single digits for companies in decline.
  • Revenue growth: Revenue is simply the total sales of a company in a given period. Wall Street demands that essentially every stock show revenue growth, or at least have a plan to do so in the near future. While profits are more important to investors, profit growth can be more volatile and is often influenced by one-time events, making them more difficult to parse on a quarterly basis. Profit growth can also come from cost-cutting, which is not always in the best interest of the company's long-term growth. Revenue growth, on the other hand, is more straightforward and consistent, and generally gives a clearer reading of a company's growth prospects.
  • Dividend yield:On financial news sites likeYahoo! Finance, annual dividend payouts are listed alongside percentages called dividend yields. The yield is the annual dividend payout divided by the stock price. It's the percentage of the stock's value that investors get paid back to them each year. The S&P 500's average dividend yield is 1.9%, while the best dividend-paying stocks pay 4% yields or higher. Note that most stocks pay out dividends on a quarterly basis, and many stocks don't pay dividends at all.

Step No. 3: Pick a sector

Beginning investors will be best off picking a stock in a sector they are familiar with. Love going to theme parks? Think about putting some coin intoDisney. Have a medical background? Check out healthcare stocks. There are thousands of publicly traded stocks in the U.S. Narrowing them down based on your own interests or experience can make a complicated process much easier.

Familiarity alone isn't enough of a reason to buy a stock, but it can give you an edge over the pros, and it will make it easier, even enjoyable, to follow the stock. You need to understand the underlying business, after all, in order to make smart investments.

It's no surprise, for instance, that millennials recently flocked toSnap Inc(NYSE: SNAP) shares after its IPO, as young people are by far the biggest users of Snapchat and therefore have the best understanding of the product. That doesn't necessarily mean Snap will be a winning stock, but those investors should have a better sense of the company's progress and when to bail if, for example, the product falls out of fashion.

My own best investment came when I bought shares ofChipotle Mexican Grill(NYSE: CMG) shortly after its IPO in 2006. As a college student in Colorado -- Chipotle's home state -- I had visited the chain several times, gaining a first-hand familiarity with it that many investors didn't have, and believed in its growth potential.

Famed fund manager Peter Lynch encouraged individual investors to "buy what you know" --a good first step for beginning investors.

Step No. 4: Bring it all together

By now, you've decided what your investing goals are, learned the basic stock market fundamentals, and narrowed down your potential choices to a sector or group of stocks you're familiar with. Now it's time to pick one.

There are a number of factors to consider, such as potential growth and valuation (P/E ratio), but perhaps the most important question to ask yourself about a stock is whether it has a sustainable competitive advantage. Warren Buffett, Founder of Berkshire Hathaway andthe world's most acclaimed investor, considers sustainable competitive advantage to be perhaps the most important criterion for choosing a stock. He looks for companies with powerful brands, a history of dominance, beloved products, and other factors that block out competition and allow a company to earn excess profits. Many of the companies I've listed above are considered to have sustainable competitive advantages, whether that's Amazon's Prime ecosystem, Facebook's network effects, or Buffett himself with Berkshire.

A sustainable competitive advantage will ensure that a company can continue growing and earning outsized profits, and stocks that have them will generally outperform over the long term.

Now, go off and do your homework -- but if you still feel overwhelmed you can always put your money in an index fund. No less than Buffett himself has argued for that strategy repeatedly, and even recommended his heirs put 90% of his estate into a low-cost S&P 500 index fund.

But before you go and do that, go back to Step #1 first and make sure it's a good fit.

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The author(s) may have a position in any stocks mentioned.

Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of and recommends Amazon, Chipotle Mexican Grill, Facebook, and Walt Disney. The Motley Fool has a disclosure policy.