Each investing style and stock picking method uses its own set of criteria to select the best buy candidates. The criteria can be divided into fundamental and technical. Fundamental criteria evaluate a company's financial condition, valuation and growth prospects. Technical criteria evaluate the performance of the stock price itself over a period of time.
Market conditions periodically drive stock prices below any reasonable valuation. A stock can come to be worth less than the business it represents. Value investors use valuation criteria such as price-to-earnings ratio (P/E), price-to-sales ratio, price-to-book ratio and balance sheet analysis to pick undervalued stocks, which they then buy and hold until the valuation returns to normal and they can sell at a profit.
The stocks of companies that grow sales and earnings the fastest tend to appreciate the most in price. Growth investors use criteria such as sales and earnings growth, a company's potential and industry trends to buy the fastest growing stocks, which they then buy and hold for as long as the stocks are advancing and the growth continues.
Growth at a reasonable rate (GARP) attempts to combine growth and value: GARP investors buy stocks of fast-growing companies with reasonable valuations and sell them when those stocks become overvalued. Many use PEG -- a ratio of P/E to earnings growth rate -- as their main criterion to select buy candidates.
Momentum investing is based on the premise that stock prices move in trends: once a trend starts, it is likely to continue for a while. Momentum investors use a stock's price and volume action as their main selection criterion to buy stocks at the beginning of a new uptrend and to sell them as soon as that uptrend begins to falter. Trend following is a variation of the same concept. The selection criteria are based largely on the stock chart patterns of both value and growth stocks.
Biotech is a specialized and risky area of investing because most biotech companies are unprofitable because they burn through cash while developing new drugs. A successfully commercialized drug can generate billions in sales for a small, obscure biotech company. Biotech investors use as their main criterion the potential efficacy of a new drug candidate and its chances of successfully passing clinical trials and getting final Food and Drug Administration (FDA) approval. Since most drug candidates are never commercialized, the goal of biotech investing is not so much to find a company with a drug that will be approved as to speculate on investor reaction to the various stages of drug development while a drug candidate is still showing promise.
- FINVIZ.com Stock Screener
- "One Up on Wall Street"; Peter Lynch; 2000
- "Security Analysis"; Benjamin Graham and David Dodd; 2008
- "Technical Analysis of Stock Trends"; Robert D. Edwards, John Magee; 2010
- Visage/Stockbyte/Getty Images