How to find the Best Stocks to Buy

ValueRays Cheatsheet simplifies finding great stocks ✓ Discover key indicators like Growth and Debt Valuations to make informed decisions.

The Four Principals of Profitable Investing

1. Find Economic Moat

  • High customer switching cost or effort
  • Unbeatable Prices
  • Intangible Assets (Patents, Trademarks, Copyrights, Approvals, Brand Names, Geographic Advantage)
  • Network Effect (Being the first mover -> Winner takes it all = legal Monopolists)

2. Buy at Fair Value or below

  • What is a low valuation for this company? (Historical P/E, P/B and P/S over the last 10 Years)
  • Discounted Cash-Flow Valuation (with a Margin of Safety)

3. Let it Compound

  • Avoid Trading (Commissions, Taxes, missing the best spots allways by 10%)

4. Know when to sell

  • Realizing it was a mistake to buy it at the first place
  • The stock became wildly overvalued
  • The company's moat has been destroyed/fundamentals are deteriorating
  • You need the money to buy a house for your family, ..

Generic Recommendations

  • Average Volume > 100,000 (> 1,000,000 for Options-Trading)
    When you're looking at stocks, it's a good idea to check if they have more than 100,000 shares traded on average each day. This usually means a smaller spread, making it quicker for you to buy or sell when you need to.
  • Market Cap > $300 Million (> $1,000 Million for Options-Trading)
    It's wise to avoid Nano Cap stocks. This helps to reduce the risk of share price manipulation.
  • Price > $5
    Its best to avoid penny stocks, as they often come with information problems and a higher risk of being manipulated.
  • Age > 2 years
    For solid research, make sure you have access to at least two fiscal years or 8 quarters of key financial data like balance sheets, income statements and cash flow reports.

Recommended Fundamental Ratios

Sources: McKinsey 1, McKinsey 2

Profitability

  • ROIC > 15%
    Look for companies with an ROIC greater than 15% for a more profitable investment choice.
  • Net Profit Margin > 25%
    Net Profit Margin is a good indicator of how profitable a company is at the most fundamental level.
  • FCF Margin > 7%
    Free cash flow is the amount of cash a company has left over after it pays for its operating expenses and capital expenditures. FCF margin is how much free cash a company generates relative to its revenue.

Growth

  • Revenue Growth > 10% YoY
    Key Driver of Long-Term Stock Performance.
  • EPS Growth > 10%
    Leads to higher stock prices, hence most investors use Discounted Cash Flow (DCF) to value stocks.

Debt

  • Net Debt / EBITDA < 3
  • Net Debt / Free-Cash-Flow < 4
  • Debt / Equity < 80%
  • RoIC > WACC

How to identify Best Stocks to Buy by analyzing the earning sheets?

Business
  • Low volatility of margins
    Historically, gross margins have been stable and predictable
  • Pricing power
    High gross margins > 30%
  • Low Capital Intensity
    CAPEX/Sales < 5% and CAPEX/Operational Cash Flow < 15%
  • Cash Flow Returns on investment (CFROI)
    (todo)
Ownership
  • Skin in the Game
    Owner & Family > 20% of shares

How to identify Best Stocks to Buy by comparing financial ratios?

Business
  • Moat
    Sustainable, high Return on Invested Capital (ROIC > WACC)
    by recurring revenues, high gross margins and low capital intensity
  • Pricing Power
    Best CAPEX/Sales in Peer-Group
Capital Allocation
  • Pattern of Disciplined Reinvestments
  • Extensive Opportunities to Reinvest
    Reinvest for organic growth (ROIC > 20%, ROIC YoY)
    Acquisitions (hard to predict which M&A createa value; 60%-90% don't)
    Share buybacks
    Dividends 20% - 25% of EPS (in absence of value creating alternatives)

How to Analyze a Stock

Understand the Product
  • Annual Reports
  • Investor Presentations, Shareholder Letters
Revenue Split
  • In which different segments does the company make money
  • How does the geographical split look like
Skin in the Game
  • Which Insiders are buying their own stock
Moat
  • Check ROIC curve of the last 10 Years
Capital intensity
  • CAPEX/Sales < 5%
  • CAPEX/Operating Cash Flow < 15%
Financial health
  • Interest Coverage Ratio (EBIT/Interest payments) > 10
  • Net Debt / Free Cash Flow < 4
Profitability
  • Gross Margin > 30
  • FCF Margin > 20
Historical Growth
  • Yearly Revenue Growth > 5%
  • Yearly Earnings Growth > 7%
Outlook
  • Secular trend (urbanization, aging, cybersecurity, obesity, digital payments, …)