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How To Pick A Winning Stock

Many investors dream about getting multi-baggers like Super Group Ltd (SGX: S10), Boustead Singapore (SGX: F9D), and conglomerates Jardine Strategic Holdings Ltd (SGX: J37) and Jardine Matheson Holdings Ltd (SGX: J36) – see here for more details about their returns over the years. Sadly, some would have lamented that they had missed out investing in these huge winners.

However, without a clear system to seek out such growth companies, it is possible that one may miss out on all the great opportunities right in front of them. So, how exactly can you pick winners?

There are several ways to do so, but one starting point would be using a list of criteria to narrow down your search for these hidden gems.

#1 Revenue and EPS Growth

The growth of a company’s sales and earnings are usually the primary drivers for the stock price. If a company doesn’t have revenue, it doesn’t have anything. But you shouldn’t just look at the latest revenue or EPS number. You should look at whether there is an increasing or decreasing trend. Obviously, increasing revenue and EPS would be preferable to a decreasing trend.

However, even a company with consistent revenue/earnings growth is not enough. Warren Buffett once said that “a good company’s goal should not be simply growing earnings, but also increasing per-share earnings”. Simply put, a company which has grown its earnings through equity dilution measures like rights issue might mask the fact that there isn’t any real earnings growth.

#2 High Profit Margins

Another criteria often cited by Warren Buffett, is to hunt for companies with high profit margins. Buffett places great emphasis on its proven track record of strong profitability.

The rationale behind this criteria is simple: If you earn one cent out of every dollar (1%) in revenue, you have to multiply your sales by 10 times in order to have the same net profit with another company that earns ten cents out of every dollar (10%).

Profit margins also show how well a company can control its costs and its ability to raise or lower prices, especially relative to other companies in the same industry.

#3 Growing Free Cash Flow

Lacking free cash flow, it’s difficult for a business to pursue new opportunities, acquire other businesses, or pay dividends. When achieving free cash flow, a company is much more capable of those things plus paying down debt, saving cash for a rainy year, and building shareholder equity. Just like what my colleague Sudhan pointed out in his article, free cash flow is essential in any business as it can be used for many measures benefitting the shareholders including reinvesting it for further growth through acquisitions or organic investment.

#4 Return on Equity (ROE)

Warren Buffett is a strong advocate of Return on Equity and has always deem it as one of the most important factors in making successful stock investments. The reason is similar to the point mentioned above – a higher ROE means that surplus funds can be invested to improve business operations without further need for more capital or borrowings. ROE can also be a good indicator to see how efficient the company’s operations are and how well the assets are put to use.

Foolish Bottomline

While the above guidelines can aid in identifying a list of potential stocks, there is still more homework to be done.  Besides the numbers, there are also other factors to look at including the management of the company. However, I hope that I’ve provided you with a starting point with which to begin your investing journey. You can learn more about investing by signing up now for a FREE subscription to The Motley Fool’s weekly investing newsletter. Take Stock Singapore, teaches you how you can grow your wealth in the years ahead!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor James Yeo doesn’t own shares in any companies mentioned.