When looking for stocks to add to my portfolio, how do I decide what to purchase? I have a few things that help me find what seems like a good share to buy that would enhance my existing holdings.
Over time, expectations can change. So what looks like a great share to buy today might still disappoint me in future. I try to mitigate that by making sure that I always own a range of different shares. When I am deciding whether or not to buy a particular one, here are a couple of factors I consider.
Long-term profit streams
To make money from a share, over time I need its price to grow, the firm to pay dividends, or both. Broadly speaking, if a company can consistently increase its profits over the very long term, that ought to help boost the share price. Profits are also what enables a firm to pay out dividends to shareholders.
To help me decide whether I think a company can make long-term profits, I look at what I think future demand for its products will be. For example, people will always need to eat, which could help support customer demand at companies like Associated British Foods.
But just being in a market with strong demand is not enough on its own. Such a market will typically be crowded. I look for a company with something that gives it a competitive advantage over rivals that can help it make profits. For example, ABF owns popular brands such as Twinings. Many customers feel there is no substitute for their favourite tea brand, so will stay loyal even in the face of price increases. That gives a company what is known as pricing power. Such pricing power can be an ongoing source of profits.
Share price
But even a good business does not always make a rewarding investment. In fact, it can sometimes make a terrible investment.
That is because investors may overpay for the shares. So, even as a business improves its results, the share price can keep falling. That is why I pay close attention to the important topic of how to value shares. People do this in different ways, such as looking at sales, earnings or future cash flows. I do not think there is a single, objectively correct method – if there was, probably almost everybody would be using it.
But whatever valuation methods I use, in my view a good share to buy must sell for less than I expect it to earn in future. So, for example, I sometimes look at a company’s expected future free cash flows. Then I consider whether, allowing for the opportunity cost of tying up my money in the shares over time, those free cash flows may be higher than the current company valuation. This is known as the discounted cash flow approach to valuation.
Finding a good share to buy
Landing on a good and rewarding share is often not easy. Millions of other investors are trying to do the same thing. That can push up the price of attractive companies – sometimes to unreasonable levels.
But I think the potential rewards can make it more than worthwhile for me.
