First, let me start with the stock selection process and portfolio construction process, and then I will tell you why I never rely on other analysts’ opinions.
I will share my approach to how I choose stocks and what are the most important moments I pay attention to. First, I divide my portfolio into shorter-term stocks (usually up to one year) and longer-term stocks (a year to five). The proportions of longer vs. shorter stocks mainly depend on my investment goals and capital. If I am investing larger capital, I will choose more stable, value stocks of well-known companies whose businesses I understand. My portfolio would consist mainly of longer-term stocks. If I have smaller capital (less than $50K), I am switching more to shorter-term growth stocks that can generate broader profits and are more volatile in nature. It is worth mentioning that I still would leave some portion of longer-term stocks in my portfolio, but this portion would be significantly smaller than the shorter-term stocks.
To know the exact portion of each stock in my portfolio (in %), I use different portfolio management models, such as the Markowitz model, to get the minimum possible portfolio loss, given my required rate of return. If you cannot use different portfolio management models or don’t have experience using them, in that case, you can use my web-based app that will help you find stocks tailored to your investment goals and help you construct your efficient portfolio. If you choose this option, you don’t have to do manual calculations and use complex financial ratios. Go to my web app, Diversset, and answer four simple questions. The app will find stocks ideal for you and construct your efficient portfolio. It is all that simple. Now, you know how to construct your portfolio and find stocks easily. But continue reading this post if you are interested in manual stock search and want to understand how the stock selection process starts for me.
To start my stock search, I start with an idea and see what the most interesting stocks for the short term and long term can be. For example, during a COVID lockdown, I was interested in discount store stocks because many people were losing their jobs and were interested in saving money. I also looked at the value stocks of larger companies for the long term because many united stated citizens were getting money from the government as help during COVID times. These people actively invested this money into popular, well-known companies’ stocks. All I am trying to say is that short-term stock selection depends heavily on the current moment and what will be the great demand among people. The long-term stock selection process depends on other things, including but not limited to a longer-term company vision, company debt structure, positive and stable FCF dynamics, good operating numbers (stable gross or operating margin), decreasing costs, and other things from the financial reports. Moreover, you should like the company and understand its operations to accurately calculate and forecast financial data.
After I finished the first stage of my stock selection process, I use financial ratios (P/E, P/FCF, PEG, and other ratios) to compare the company to its closest peers to answer the question is my selected company’s stock trading cheap to its peer’s stocks or I should consider other stocks from the peer group. It is worth mentioning that the financial ratios you will use depend on the company industry, its product, or its service. Never use only standard ratios because if you do so, you risk missing critical key elements in the financial data and coming up with the wrong conclusions.
After I found stocks that look cheaper than their peers, I start analyzing the company, its business, and its services. I read the management’s letter and try to understand the management’s vision regarding the company’s long-term goals, its expansion, market share, and the current challenges. I need this information to make accurate forecasts when I go to the next stage.
Now I can examine a company’s financial statement to make financial forecasts; I am examining costs, income, revenue, asset, debt structure, and FCF. I also examine the cost of money on the money market. It is all done to forecast its FCF and calculate WACC (required rate of return). Then I calculate the company’s terminal value, discount TV, and FCF by the WACC, sum everything up, and get the company’s Enterprise value. I then add cash and subtract the company’s debt to get the company’s market capitalization, and finally, I divide market capitalization by the number of the company’s shares. I get a company’s target price. This model is called DCF. I use this model mainly for larger companies. I consider the company a good investment if its target price is at least 20% higher than its current market price. The stock target price approximates the future value of the company’s stocks based on the forecasted financial data. Now, suppose I deal with shorter-term, more volatile, growth stocks and a smaller company. In that case, I usually use another model, DDM, where I forecast dividends using the Prat and Gordon model and then discount the dividends by the required rate of return. If the company is small and not paying dividends, I may use only multiplicators and skip this step. In this case, I only compare the company’s financial ratios to its closest peers. If you don’t have expertise in calculating stock target price or don’t have time for manual calculations, you can use my iOS application to calculate the stock target price if you have an iPhone. The app is called Stock Target Price, and it is available on the app store.
After I came up with the list of value and growth stocks and decided that I would buy them, it is time to construct a stock portfolio. I can use my web-based app or use manual calculations to do this. For manual calculations, I use Excel and The Markowitz model. This process aims to know precisely what percentage of each stock should be in my portfolio to get the lowest possible expected loss, given my required return. If you are interested in getting detailed explanations on how to allocate assets and calculate stock target price manually, you can take my course on stock valuation and portfolio management on Udemy.
Now let me tell you why I never rely on other analysts’ opinions. This is because analysts’ view, including stock target price calculations, is very subjective. You don’t know the analysts required rate of return, how they forecast FCF, and what data they examine. You also don’t know their investment goals and cannot say the most important moments they are paying attention to. Analysts’ goals can differ from your goals, and they use their custom models that they are not sharing with the public. If you examine analysts’ stock target prices or financial data forecasts, you will notice that the estimates and calculations vary significantly from analyst to analyst. All the calculations are subjective, and analysts have their assumptions. That is why it is a good idea to use your models. Or you can choose the analyst you trust and select his analyst. It would be best if you decided for yourself will you be using some analysts’ calculations and read their research reports or will you use your models. You can also use my iOS application, “Stock Target Price,” to calculate the stock target price and growth potential and define the excellent stock entry and exit point.
Now, you know about different models and how analysts use them to undertake equity valuation and construct an efficient portfolio. I hope my article was helpful. Please let me know what you think in the comments section. And let me know if you need video tutorials on calculating stock target price and constructing an efficient portfolio. And I can make video instructions and upload them to my YouTube channel if you want. Thank you for reading.