If you have no clue how to pick stocks, and you want to learn the 4 factors you need to consider before buying a stock, then this post is for you! I’m going to explain the 4 KEY METRICS to look at for a stock before you risk your hard-earned money on any investment.
Understanding these metrics will make it easy for you to distinguish between a shitty investment vs. a great investment. I’ll also show you WHERE to look up this info so that by the end of this video, you’ll be able to do your own research at home. If this sounds good to you, then watch the video below or keep reading!
#1 – Economic moat
The first factor to consider when buying a stock is whether the company has a competitive advantage or not. Warren Buffett calls this an economic moat. You all know what a moat is, right? A moat is a ditch filled with water that surrounds a castle to protect it from enemies. The wider and deeper the moat, the safer the castle is from getting attacked. When it comes to investing, you want to buy stocks of companies that have wide moats. The moat is a company’s ability to protect its profits and its market share from its competitors. Without a moat, competitors will cut into profit margins, steal customers, and eventually put the company out of business. This is just Business 101. All good companies have some sort of secret sauce that makes it stand out from the competition.
Never invest in stocks without a moat. Why? Because for long-term investing success, you need that company to be around in the future. And the only assurance that the company will still be around in the future, is its moat. It’s a competitive business environment out there, so you want to invest your money with companies that have really wide, durable moats.
Here’s an example:
CRUMBS was a very successful cupcake company that started in New York City. Before CRUMBS, gourmet cupcakes weren’t really a thing – so when they came on the scene, they started this whole cupcake fad and people were buying CRUMBS cupcakes left and right.
Pretty soon, all kinds of new competitors started popping up everywhere to get in on the action. Eventually, profits started declining and the company went out of business a few years later. Sure, CRUMBS was the first gourmet cupcake shop ever, but it’s not like they had a secret recipe, or a well-known brand, or any kind of edge over other cupcake shops. So this is exactly why having a moat is so important.
Here’s another example:
Coca-Cola has been around for 100+ years and has an unbelievably strong moat. There’s tons of competition making generic copycats of Coca-Cola, but because of Coca-Cola’s iconic brand name and its worldwide distribution network, they’ve maintained fat profit margins for the last CENTURY! This shows in the stock price – anyone who invested in Coca-Cola has done very very well.
Moats can come in many different forms. Coca-Cola’s moat was due to brand name and economies of scale. Other types of moats are:
- Trade secrets: Align
- Network effects: Facebook
- Toll bridge: Google
- Lower costs: Walmart
So before buying a stock, you want to ask yourself “What type of moat does this company have?” You also want to ask yourself, “How durable is this moat?”
If you can’t think of anything, then chances are, it doesn’t have a moat! If that’s the case, you should cross this stock off your list and move on.
#2 – Profitability
Before you invest in a stock, you also want to consider profitability. Is this company profitable? The best way to measure profitability is with a metric called Return On Capital (or ROC for short).
ROC = Net Income / Invested Capital and it’s expressed as a percentage. You can either look up the financial statements and calculate it yourself, or just get it straight from online data sources like morningstar.com.
ROC is important because it tells you how good a company is at generating profits, given a fixed amount of resources. Yes – profit is great. But what’s more important is HOW MUCH IT COST to generate that profit. Because what if I told you that my business made $100k of profit last year, and there was a total of $10m invested in the business. That’s a 1% ROC… not good! That’s not a special company by any means and definitely not one I’d consider investing in.
On the other hand – what if the business made $100k of profit last year, on only $10k of invested capital? That’s 1000% ROC…. Whoa!!! Now THAT’S a special company.
Companies with high ROC do a lot with a little. Companies with low ROC do a little with a lot. If you’re considering a stock with high ROC, it probably means it has a strong moat, and you’ll be getting a lot of bang for your buck with your investment.
So as a rule of thumb, you want to look for high ROC when buying a stock. My examples were a bit exaggerated so you’ll probably never see anything with 1000% ROC, but anything in the high-teens or double digits is good enough. As a point of reference, Coca-Cola has maintained ROC in the mid to high 20’s (although that’s been declining steadily over the years… even the best moats eventually have an expiration date). 20%+ is pretty exceptional, 15% is great, anything below 10% is questionable, and you definitely don’t want to see a ROC that’s negative.
#3 – Price
Now let’s talk about price. So you found a company that you understand, that has a moat, and it’s profitable. But you don’t want to just buy it at any price.
Even the best investment turns into a horrible investment if you pay too much for it. So this is where the PE ratio comes in. The PE ratio is a metric that tells you how EXPENSIVE (or cheap) a stock is relative to the earnings it generates.
Here’s how it works:
PE ratio = Current Market Price / Most Recent Reported Earnings
Let’s look at an example. As of June 2019 AAPL had a PE ratio of about 15. This tells me that if I want to invest in AAPL, I have to pay 15x earnings to get in on a piece of the pie.
Now what if the stock price dropped tomorrow? That would reduce the numerator in the equation, so the PE ratio would go down. All other things being equal, wouldn’t you rather buy AAPL at a PE ratio of 10x than 15x? Given a fixed earnings number, I’d rather pay less to own the stock than more.
But let’s say AAPL’s stock price dropped tomorrow, but its earnings also dropped by an equal proportion. Then guess what… the PE ratio doesn’t change! So even though AAPL’s stock price went down, making it look chepaer, since the PE ratio is exactly the same, I didn’t necessarily get a better deal.
That’s why when you talk about stock price, you always want to look at it RELATIVE to earnings. Generally, when you’re looking to invest, you want to buy stocks with relatively low PE ratios. Especially if its PE ratio is usually higher but it drops for whatever reason – that means the stock is trading cheap and is probably an amazing bargain!
PE ratios are super useful to know about, because when you buy something cheap, you reduce your risk by A LOT.
Like if you bought something cheap – at a low PE ratio – there’s not a lot of room for it to get much cheaper, right? Whereas if you buy something expensive – a stock with a high PE ratio – there’s a higher chance of it going down and it’s not as safe of an investment.
#4 – Debt
Before investing, it’s also very important to consider how much debt a company has. Most companies have debt, so although debt isn’t necessarily a bad thing, it’s a double-edged sword.
As long as the company has enough cashflow to pay the interest and principal on its debt every month, then debt is just part of running and growing a healthy business. What you DON’T want to see is a company with loads of debt on its balance sheet, and it owes so much that it would take forever to get out of debt, or it even borrows money to service its existing debt (believe it or not, there are companies like this!). These are red flags you definitely want to watch out for.
Here’s how you assess debt:
You divide LT Debt / Free cash flow. I call this the debt payback time. This number tells you how many years it would take for the company to pay off its debt with its cashflow. A good rule of thumb is 3 years or less.
Highly leveraged companies are risky, because if for whatever reason, there’s a downturn and revenues fall for a while, that puts the company in shaky territory because its debt payments are fixed, while its revenues are variable.
It’s the same with you, if you have tons of credit card debt and your monthly payments are super high, then you’re in big trouble if you lose your job or start making less money for whatever reason, right? Having a lot of debt makes everything riskier and leaves very little room for error.
If a company can’t make its debt payments, it will have to declare bankruptcy. That could mean the stock price goes to zero and you lose your entire investment! We definitely don’t want that to happen. I don’t want to scare you though – almost all companies have some form of debt. It just needs to be a manageable amount. So just stick with conservatively financed companies and you will be fine.
Alright now I want to hear from you:
What stocks have you thought about buying, and why?
Join me in the comments below and let’s motivate each other to get started investing!
That’s all for today, thanks so much for reading. If you liked this post, please share it with your friends so we can open up the conversation around money AND build a sisterhood of financially savvy, empowered women.