Have you ever wondered what makes a stock a buy (also known as a buy rating)?
Trying to invest in stocks and deciding which ones are a buy does not have to be hard.
I wish these were the kinds of questions that are brought up more often in school. Not just on how to invest, but also things like taxes or paying off debt. Have you every wondered: If taxes are something that every citizen must pay once a year, wouldn’t it be good to teach us early on? Or how about teaching us how to value a business – something value investors must be able to do.
Most people can manage to set up an account to invest. This is called a brokerage account.
A brokerage account is what you will need to invest in individual equities. Other kinds of accounts include 401ks, which most middle-class individuals have. Still, you can open other types like IRAs, HSAs, and even whole life insurance policies which you can borrow against.
If investors are going to go along on this journey of selecting stocks themselves, it is best to know what makes a stock a buy.
One thing I’ve learned from other investors is that many have a list of criteria (or a checklist) that can be useful with this process.
Here are the top 13 questions investors should ask before buying stock.
- Does the company have a competitive advantage?
- How does the company fit into the world?
- What is the downside potential?
- How has the company been run by management?
- Does the company have positive owner’s earnings?
- Is the company selling below its intrinsic value?
- Is the margin of safety large enough for your needs?
- Does the company have to much debt?
- Does the company fit into your level of competence?
- Does the company have low margins?
- Does the company have a return on invested capital?
- What does the competition look like?
- Does the company pay a dividend?
Does the company have a competitive advantage?
If you’ve ever been apprehensive about buying stock on your own, this is the most important question to ask. The reason why this is so important is because a competitive advantage is what can guarantee that a company will last into the future.
Another thing to think about on this topic is can you safely see this company in 20 years? Can you predict how it will fit into the world then? If you cannot imagine or if you think there is a good chance the company will fail, you shouldn’t buy shares.
How does the company fit into the world?
One of the best things an investor can do before buying stock is think about the asset(s) they are buying. This may sound too simple but too often individuals only think about the stock chart they are looking at.
Does the company make a product or provide a service that the world isn’t ready to give up? Thinking about the economics of the business can tell you about future growth and how likely there is to be any.
What is the downside potential?
One strategy for buying stock can be to reverse engineer our thought process. Instead of asking what makes a stock a buy, ask yourself what doesn’t?
If a company doesn’t make any money and you can’t answer the two questions above, that very likely could be a company you do not want to buy stock in.
Furthermore, also asking yourself what could go wrong with this business is something you should always think about before buying stock.
How has the company been run by management?
As a smaller investor, one thing often hard to understand is how the company you want to buy stock in is being managed.
Let’s face it, there’s probably no one sitting on the board of a Fortune 500 company waiting to speak to you on the future of the business.
One piece of information I like to view is something called the proxy report. A proxy report is a document required by the Securities and Exchange Commission (SEC) to be filed annually so shareholders can make informed decisions on matters that will be brought up at the shareholder meeting.
This document contains information like:
- Who gets elected to the board
- Who gets to audit the company’s financial statements
- Director compensation
- CEO compensation and employee pay ratio
- Company stock splits
- Other matters requiring voting
As you can see, a proxy report is something that can give you a sense of how the board manages the company and if they have customer and shareholder values in mind.
Does the company have positive owner’s earnings?
Owner’s earnings are defined by Warren Buffett as the following:
- Net income + depreciation + depletion + noncash charges + amortization – capital expenditures + working capital +/- deferred taxes.
Don’t get overwhelmed by the equation. In summary you can usually take the operational income of a business and subtract the expense known as “capital expenditures” to get owners earnings.
This amount is often known as “free cash flow”.
This metric is used by investors because it gives you an idea of how much cash is left over after a company spends what it needs to keep the assets running.
Buffett would describe owner’s earnings as such because its how much money an owner of the business has left over.
Is the company selling below its intrinsic value?
What is intrinsic value?
Intrinsic value is simply the cash that can be taken out of a business in its remaining life, discounted back to present day value.
I love the concept of valuing a business based off intrinsic value because it makes investing simple.
The concept of intrinsic value is basically stating that a company is valued based off the cash that it will generate in the future.
The greater the cash produced, the greater the value.
Therefore, if an investor cannot easily determine a range of cash that can be produced by a business in the coming years, should this be a stock worth investing in?
Is the margin of safety large enough for your needs?
A margin of safety is a safety net for your protection. Going off the intrinsic value concept above, a margin of safety is the difference in the price you pay for a stock and what you think that stock is worth.
For example, if I buy XYZ stock at $20 a share and I believe it should be selling at $25, my margin of safety is $5.
The question left for you to decide is if that margin is large enough for your protection.
Some factors when deciding on the size of the margin of safety can be:
- Growth: is the company in a large growth period? If so, you may want a larger margin as these stocks tend to have greater volatility
- Sector: what does the company provide or produce? If the company makes food versus some new invention unseen before, I will argue more risk lies in the latter.
- Temperance: how well do you know yourself? If you have a hard time controlling your emotions, then not having a large margin of safety could hurt you.
Does the company have too much debt?
One of the first items I look at when deciding to by stock is how much debt there is.
As simple as it my sound, a company with a lot of debt will only struggle more when times get tough.
Imagine what it was like for companies that struggled during the pandemic in 2020. Many companies could not afford to continue their operations because of issues outside of their control.
Now imagine how much more difficult it was for businesses to remain open when they had a pile of debt on top of dismissal revenue income.
The truth is none of us know the future of a stock. However, one thing for certain is that the more debt a company has, the harder it will be when times get tough.
Does the stock fit into your level of competence?
Remember, competence is your ability to have knowledge in a particular subject.
Buying stock in a particular company or industry that you are not familiar with is setting yourself up for failure.
One of the best things an investor can do when deciding to buy stock is acknowledging that some investments are not for all.
I talk more about your level of competence here.
Does the stock have low margins?
An important metric to look at when buying stock is the size of the company’s margins.
There are 2 main margins to look at:
- Gross margin: this tells you how much cash is left over after a company pays for its cost of goods.
In other words: revenue-cost of sales=gross income
- Net margin: this tells you how much cash is left after all expenses have been accounted for. These expenses include items such as interest, cost of goods sold and taxes.
If we look at Walmart’s net income statement, you can see the company’s small margins.
After doing some math, Walmart has a net margin of around 2.4%.
With that said, the company is fully aware of the fact. Part of its business plan is to sell more at lower prices. The result is smaller margins, but the company can afford to operate this way because of the volume of goods it sells.
The question any investor must ask is whether they are comfortable buying stock in a company that operates this way.
The smaller the margin, the less room there is for error or unexpected business affairs.
Does the company have a return on invested capital?
What is return on invest capital? (ROIC)
Another import metric to consider for buying stock is the percent return that is generated on invested capital. Another way of asking this is what is the company earning from the capital it is investing back into the business?
You can often easily look these items up online. Some of my favorite resources to check something like ROIC is www.Morningstar.com and www.macrotrends.com.
The ROIC is important because if a company cannot say that it is getting anything out of the capital it is putting into the business, what is the point in the first place?
What does the competition look like?
You should always check out the competition before buying stock in a company.
This is one of the best ways to see if there is some type of competitive advantage present.
Or another way of looking at this question is, how is the stock I want to buy going to be able to keep market share away from others?
Does the company pay a dividend?
Finally, paying a dividend is one of the reasons we invest to begin with.
Dividends give us the ability to reinvest our share of the company’s earnings. Therefore, it is this way that allows compounding interest to take affect.
For example, according to Buffetts 2021 annual letter from Berkshire Hathaway, the company earned an astounding 785 million dollars from their investment in apple in one year.
Now, most of us don’t have that kind of money to invest. Yet, it alludes to the benefit that buying stock can have for investors. Dividends are the portion of earnings that you collect based on your ownership in the company.
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