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Investing in winners! 3 ways I’d identify shares with huge potential

There’s much more to investing than the three steps I’m identifying in this article but the reason for outlining them is that they are three of the key steps I think will help separate the wheat from the chaff, giving you, the investor, the opportunity to do further research to uncover ‘winners’ that can grow in value.

Buy shares on modest valuations

With property companies and investment trusts, valuations are often easy to calculate. You can take the net asset value (NAV) and compare that to the share price to see whether a company is trading at a premium to what its assets are worth, or which one has its risks in terms of the share price being expensive (or at a discount), and which one has its upsides and downsides.

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The upside is that if the share price is lower than the value of the company’s assets, it should eventually rise. But the downside is that investors may just not like the assets the company holds. For example, too many high street shops that are at risk of closing down can account for the discount. As always it’s vital to do your own research. 

For other listed companies, the price-to-earnings ratio will indicate the valuation of the business. The lower the figure the better, from a value point of view, but always assess whether a company is cheap because the business isn’t working or is in trouble. If it isn’t, but is cheap, then buying could be very rewarding.

Record of profitability and dividends

To invest in companies that are ‘winners’ you want to be able to see a track record of year-on-year rises in profitability, ideally in the form of operating profit or profit after tax, and a rising dividend. It’s important though to assess a company’s ability to keep paying a rising dividend so make sure to also check the dividend cover.

This can be calculated by dividing earnings per share by the dividend per share. Ideally, I’d suggest looking for cover that is greater than two, as this reduces the likelihood of a cut and increases the sustainability of the dividend. 

Companies that are profitable have shown there is demand for their product or service, that they have a handle on costs and so are less risky than, say, biotechs or little oil explorers that often need more cash from investors and potentially could never reach profitability.

Dividends are a way of working out if a company is profitable because generally speaking, they can only be paid out of profits or reserves.

Management quality with meaningful holdings

In smaller companies and family-owned businesses the value of shares management holds is an important indicator of the board’s confidence. Having ‘skin in the game’ aligns the interests of management with shareholders, which should benefit both parties.

In bigger companies, it’s much harder to build a large percentage of management ownership because the companies are worth billions. Nonetheless, even with FTSE 350 companies, ideally you want to see management actively buying shares rather than selling them or just being rewarded with them as bonuses.

I hope that these three simple tips will help you as an investor to find companies for your investment portfolio that have plenty of future potential.

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Andy Ross has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.