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While the COVID-19 pandemic has caused the global economy to freeze, capital markets have showed a less pessimistic picture. For instance, the S&P 500 Index, which measures the stock performance of 500 large companies listed on the stock exchanges in the US, has fully recovered from the loss in March and been back to the positive territory, recording a year-to-date gain of 4.73% as of 14 September 2020.

Retail investors with limited resources often struggle to pick the right stocks, especially amid uncertain markets like this.

“Picking stocks isn’t simply a matter of choosing a few companies you like, then executing some trades—just because a company makes stellar products doesn’t guarantee it will be a good investment,” says Steven Greiner, Senior Vice President at Charles Schwab*, one of the world’s largest financial conglomerates providing a full range of brokerage, banking and financial advisory services.

An investment strategy that professional investors has been using to navigate volatile markets is value investing. It is a strategy focusing on the fundamentals, aiming to identify companies that might be undervalued in the marketplace.

“To find quality stocks that have the potential to go the distance,” he shares, “it’s important to dig into their financials.” And followings are his four favorite metrics for evaluating the financial health of such stocks.

1. Price-to-earnings ratio

Looking at a company’s price-to-earnings (P/E) ratio—that is, its current stock price relative to its earnings per share—is useful for determining its intrinsic worth relative to its market value. A lower P/E ratio, for example, suggests the stock may be underpriced and could have room to rally.

Some investors look at a P/E ratio based on expected earnings; however, that introduces another layer of guesswork. Therefore, it is suggested sticking with historical earnings and looking at profits over the past four quarters. And since these ratios tend to vary between sectors, comparisons of the P/E ratios should be made for companies within the same sector.

2. Return on equity

After gauging a company’s valuation, investors may want to know about the quality of its earnings. Does the company have the financial strength to maintain its profits or, ideally, to grow them? One way to assess this is by looking at its return on equity (ROE), or how efficiently the company uses its capital. One formula for determining this is:

net income ÷ (assets – liabilities)

A higher percentage is better, but, as with P/E ratio, a company’s ROE should be assessed relative to its peer group.

Though, investors should be aware that a sudden jump in ROE may be due to an increase in a company’s debt—not an improvement in its profitability. So always check to see whether a company’s debt levels have changed significantly.

3. Volatility

Swings in the price of a stock can be an indication that investors are uncertain about its earnings. What is the degree to which the daily share price fluctuates relative to its industry peers? Generally speaking, a stock with lower-than-average volatility appears the better choice, as it may signal steadier earnings.

4. Momentum

Increasing investor interest is a positive sign, all else being equal. If, over the past six months, a stock’s price has broken above the range it had been trading within for an extended period, the stock could have momentum and may continue to climb. That said, positive momentum is more like extra credit and shouldn’t trump other metrics such as valuation.

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“These four metrics are a start, but successfully picking individual value stocks is difficult, mostly due to the amount of research and time it takes,” says Greiner.

In addition, Schwab Equity Ratings, a value-added service for its clients, may be a useful tool.

Greiner explains, “It is a system we developed at the Schwab Center for Financial Research that evaluates some 3,000 US-traded stocks using a wide variety of financial metrics. We assign each stock a letter grade from A through F, depending on how likely we think it is to outperform or underperform the market over the next 12 months. Stocks that earn an A rating, for example, are expected to strongly outperform the market, while those that earn an F are expected to underperform.”

“We are dedicated in equipping investors with the required skills and knowledge to pick their own stocks, and providing them with the right tools to facilitate their investment decision making.” He concludes.