This week, we’re dealing with a question that is pretty fundamental to investing - how should you decide which shares to buy? Researching companies is a lifetime’s work for some people but that doesn’t mean novice investors can’t make sound investment choices for themselves armed with just a few simple ideas and concepts.
Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.
In this article:
If you’re reading this the chances are that you’re already sold on the benefits of buying individual company shares - now comes the task of actually picking what to invest in.
Unlike those investing via funds, those investing directly in shares are taking on the responsibility of not only choosing company shares to buy in the first place but of monitoring their portfolio and deciding when to buy and sell on an ongoing basis.
There are professional investors whose full time job is to research and buy shares and it’s hard to imagine many private investors can match that level of expertise - but that doesn’t mean individuals can’t also invest successfully by applying some simple principles and learning the basics.
This guide aims to introduce first-time share investors to some of those principles and ideas so that they can begin the journey for themselves.
Large or small? Why the size of company you invest in matters
There are thousands of companies listed on public stock exchanges that you could buy, so learning ways to group these off into smaller areas for you to research and decide between is a useful first step. Perhaps the easiest to understand is size - is a company large, small or medium sized? Each will offer investors different opportunities and levels of risk.
‘Market capitalisation’ - or ‘Market cap’ for short - is a measure of a company’s size. It’s a monetary value equal to the value of all the company’s outstanding shares added together. Stock market indexes group together companies according to their size. The FTSE 100, for example, is a list of the 100 largest companies listed on the UK stock market.
The largest companies are already well-established. They have reliable ways to earn revenues which means they should be less likely to suffer large shocks that wipe out their value. But, because they are already very big, their potential to grow very quickly is reduced when compared to smaller companies.
Small companies offer this rapid growth potential but come with extra risk. Small companies tend to have less diverse streams of revenue so can be knocked off course more easily.
How you split your money between larger and smaller companies will depend on your investing goals and appetite for risk.
This chart shows the performance of UK smaller companies, represented by the FTSE Small Cap Index, versus large companies, represented by the FTSE 100.
Five year performance
|(%) As at 30 Sept||2015-2016||2016-2017||2017-2018||2018-2019||2019-2020|
|FTSE Small Cap||14.4||18.0||5.1||-2.9||-5.4|
Past performance is not a reliable indicator of future returns
Source: Refinitiv, total returns as at 30.9.20. Chart shows the value of £100 invested in the two indices from 31.12.85 to 30.9.20, total returns without any charged deducted.
Defensive or cyclical? Understanding sectors and industries
The stock market can be divided up into sectors which group companies together according to what they do and how they behave when compared to the wider market. Sector examples include energy, healthcare, financial services and basic materials - there are 11 in total.
Each sector itself contains a number of industries, each doing different things. For example, the Industrials sector contains the airlines, electrical equipment and waste management industries. When deciding on a company to invest in, it is useful to compare it to other companies in its industry and sector.
A well-diversified portfolio is likely to have some exposure to most or all sectors, and a good spread of industries, in order for it to be able to hold up in different market conditions.
As well as telling you what a company does, sector and industry groupings can indicate how a company may behave from an investment point of view.
Some sectors are regarded as ‘defensive’, which means that they have the ability to trade consistently no matter what the wider economy is doing. For example, the grocery industry sits in the ‘Consumer Defensive’ sector. It’s defensive because grocers, including supermarkets, sell the essential items that we are all likely to need every day, and that’s unlikely to change much even if there is a downturn.
‘Cyclical’ companies are those who are more influenced by the economic cycle. This simply means the ebb and flow of the economy as growth increases for periods and then slows. Cyclical companies do best - and will outpace defensive companies - when the economy is on the up but they are likely to lag if there’s a downturn. For example, the luxury goods industry - which sits in the ‘Consumer Cyclical’ sector - should do best when the economy is improving, when people feel secure in their jobs and when they have money in their pocket.
Holding a mix of both defensive and cyclical companies means your portfolio has the potential to hold up in different economic conditions.
|Defensive sectors||Cyclical sectors|
|Consumer Staples||Consumer Discretionary|
How to value companies - price-to-earnings and growth
A company’s share price is a cash figure, but on its own it doesn’t tell you anything about whether that the company is cheap or expensive.
To find that out, investors compare a company’s price to other factors. Experts will use a range of different valuation methods and some require specialist knowledge or in-depth research of a company’s finances, but others are easier to grasp and are more readily available.
The most commonly used is the ‘price-to-earnings’ ratio, often described simply as ‘p/e’. This is a number which shows how a company’s share price compares to the money it makes. The higher the number, the more expensive the share is. For example, a company with a price-to-earnings ratio of 10 is cheaper than a company with a ratio of 20.
It is calculated by dividing the share price by the earnings-per share, which is itself reached by dividing the company’s profits by its number of shares. Don’t worry if that seems like a lot of maths,
an updated price-to-earnings figure for most companies will be readily available online wherever you research shares.
The price-to-earnings figure you see most often usually applies to the earnings made in the past 12 months. Bear in mind that those earnings may not be repeated in the next 12 months. You’ll sometimes see another version of the figure, known as ‘forward price-to-earnings’, which does the same calculation based on what the company expects its earnings to be in the next 12 months.
A price-to-earnings ratio is a quick way to assess the valuation on a company and can be compared to those of other companies, as well as its own historical price-to-earnings to show you whether the company has become more or less expensive over time.
Price-to-earnings on its own, however, only tells you so much. In a comparison between two companies, one may have a higher price-to-earnings ratio which makes it look more expensive, but that may be because the market believes its earnings from that point onwards will grow more strongly, and therefore justify a higher price now.
A measure called the ‘Price/Earnings-to-growth’ ratio - or PEG for short - accounts for this. It’s worked out by dividing the p/e ratio by the expected annual growth rate. Again, that sounds complicated but PEG figures are also commonly published alongside share prices.
The calculation produces a figure above or below 1, with PEG below 1 often considered cheap and above 1 expensive. Both price-to-earnings ratio and PEG can be found if you use our ‘Chart & compare’ tools.
Podcast: hear from our Insights team about how they choose shares
Looking for dividends - and how to assess them
Dividends are a way for companies to reward shareholders by distributing the money they make. It is up to the company’s management whether to pay dividends and they can decide to make regular dividends or one-off special dividends.
It is often well-established companies which pay regular dividends, while still-growing companies may see more benefit in retaining profits to reinvest in or expand the business. That means most dividends tend to come from large companies.
Investors seek out dividend paying companies for a variety of reasons. Getting a cash return via dividends helps them derive an income from their investments but, even if they are investing for growth as opposed to income, dividends can still be attractive because the money can be reinvested to buy more shares, generating a potentially higher total return. Dividends from a company are not guaranteed but they tend to be more stable than share prices themselves, so a total return which includes dividends can be more steady.
When looking at dividend paying shares, the most common expression of dividend value is the ‘dividend yield’. This is a percentage which shows the expected dividend return from buying the shares at that point, based on dividends paid in the past 12 months. It is only a guide - if the dividend is cut or cancelled altogether, the dividend yield will not be fulfilled.
If a company has a high dividend yield it could mean it is an attractive investment - but it could also mean investors are sceptical that dividends will continue to be paid. To make that assessment, investors can use measures such as ‘dividend cover’ to judge how secure the dividend is. Dividend cover is a ratio worked out by dividing the earnings-per-share by the dividend-per-share. Dividend cover of one means the value of the dividend is covered exactly by earnings, below one means it is not covered.
As a rule of thumb, many investors consider dividend cover above 2 to indicate a dividend is affordable for a company, while cover below 1.5 could mean the payment is unsustainable.
Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. Investors should note that the views expressed may no longer be current and may have already been acted upon. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.
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