Friday, March 30, 2007

Criteria For Buying a Stock

Below are the criteria that I use when I'm interested in a stock.

I’d rather buy a great company at a fair price, than buy a fair company at a great price.”
– Warren Buffett.

Criteria for a Value Play

To begin with, I look at the sector as a whole. For example, a common sector for a value play would be the financial industry. Since their business is money, financial institutions are handling a lot of it. Their market caps (stock price x amount of shares) are typically very high. Initially, I’ll take a look at a company’s competitors to determine who is best allocating their revenues. Some things I’ll take into account here would be how high are their profit margins? How many people are they employing? How fast are earnings and revenues growing?

After that, I want to look at their profitability ratios, such as return on equity and return on investment. Here, I like to see double digits in each category on average. I’ll usually expect more from a larger company though.

I then want to look at their financial statements. I like to see current assets higher than current liabilities. The balance sheet will show me how much debt they have. I like to see where the debt is allocated, because sometimes debt is not at all bad. Maybe they just acquired another company, or are expanding rapidly. I like to note if a company is consistently raising its dividend (usually a good sign), and if they are buying back stock (also, usually a good sign). I’ll also take a look at their statement of cash flows to determine what they are doing with their cash. I like to see a large amount of free cash flow here (Cash flow from operating activities – Capital expenditures).

I’ll also look at the ownership. Who are the major holders of the stock? What percentage of the stock is owned by insiders? A high number is good, because if management owns a lot of the stock, they are sure to try to maximize returns. I also look at who the major institutional holders are. There are a few fund families that I like to see as owners of the stock. (Typically Vanguard, Fidelity, Legg Mason, T Rowe Price, Dodge and Cox are a few of the best that I like to see). Has there been insider activity? Typically if insiders are buying the stock, that is a good sign.

I’ll also look at the analyst estimates. The key numbers to look at here are this year’s earnings and next year’s earnings. Quarterly earnings can vary so much that they often aren’t useful. I like to see what I call the “analyst creep” or to see their estimates creeping higher within the last few weeks.

By this point, if I’m still interested, I go to the company website. Here I’ll take a look at who their management is. How long have they been there? I’ll also read at least last year’s annual report, and pay attention to their letter to shareholders. This is a great way to get a feel for what their core businesses are.

Finally, I’ll look at stock price. But this isn’t done until I’ve determined that it is a company that I want. Some things to look at:

-Price to Earnings (P/E) Ratio. This is probably the most commonly looked valuation tool. I like to see below 15 here, but not always.

-Price to Sales (P/S) Ratio. This is comparing market cap (price) to revenues. I love to see a ratio below one here, as it tells me that the company is bringing in the value of the entire company in revenues every year.

-Actual share price. Where is it in terms of 52 week highs and lows?

-Charts. The one year chart is most valuable here.

-Moving averages. I like to buy stocks when they dip below the 50-day moving average.

-Volume traded. If the stock is making a move, is it done so on higher than average volume? Typically low volume moves are moves that are predicated on anything strong and often the stock doesn’t hold them.

-Amount of short interest. How many people are shorting the stock? Over 10 percent of the float is usually a warning sign that the stock has been overbought.

In taking all of these items into consideration, I am able to filter out which companies to buy.

2 comments:

ilanit said...

How can you know what the latest Orange County equity investment advice is? If you do not have time to spend every day looking for the investments you should be investing in,consider hiring a full service stockbroker. These guys take a straight fee of what they make for you and they give good advice that you can take with you to the bank.

ilanit said...

How can you know what the latest Orange County equity investment advice is? If you do not have time to spend every day looking for the investments you should be investing in,consider hiring a full service stockbroker. These guys take a straight fee of what they make for you and they give good advice that you can take with you to the bank.