I started investing in stocks and mutual funds back in college (~3 years ago). There were some simple things that went overlooked that I did right, and a whole bunch of things I overlooked that I shouldn’t have.

My portfolio consisted of Chipotle (CHP), Sirius Satellite Radio (SIRI), On Semiconductor Corp (ONNN), and ReGenerex Pharmaceuticals (RGN).

I purchased Chipotle for all the right reasons and the rest of my portfolio for the opposite. Essentially I bought Chipotle because I ate it — a lot. I was their most loyal customer. Chipotle had quality food, at a good price, with a streamlined service queue. And I probably ate it 4 times a week.

The rest of my portfolio was based on tips and hunches, nothing more. I bought RGN on a tip from a friend. I didn’t know their business model, and I definitely didn’t know how much volatility exists in the biopharm industry. And I certainly didn’t know what happened during trial phases.

SIRI seemed like a good buy after just grabbing Howard Stern. However, I failed to look at several factors. XM was a major competitor. They are both losing money (it costs millions to get satellites up). Are there other products that could disrupt the market (e.g. iPod).

About a month ago I started getting into investing again. This time I am determined to do it right. Armed with a realization that there is a lot I don’t know, but more importantly knowing what to look out for, I am prepared to do it again. I started researching for methods by which others value a company. I decided to come up with a checklist for things to look for before buying a stock.



Short and sweet checklist

First let me give you a run down of the things I look at. Then I will describe how I figure out if I have a green light.

    Future Potential

  • [detail] Is the stock in a hot sector?
  • [detail] Earning growth between 15-30%
  • [detail] Solid Morningstar Grades
  • [detail] 12-month price target is above the current stock price
  • [detail] Earnings growth percentage is higher than its industry

    • Technical Metrics

  • [detail] Current stock price is above it’s moving average
  • [detail] Expected return is greater than return on cost of capital

    • Fundamental Metrics

  • [detail] Higher Return on Equity (ROE) than its competitors
  • [detail] High insider ownership
  • [detail] Institutional ownership of at least 30%
  • [detail] Avg daily volume is >100,000 shares
  • [detail] PEG/YPEG near 1 (or less)
  • [detail] Price/Sales ratio less than 10. (or 3-5 for growth and <2 for value stocks)
  • [detail] Debt-to-Equity (D/E) ratio below 35%

    • Financial Health

  • [detail] Increasing revenue over the last four quarters and increasing year-over-year revenue totals
  • [detail] Increasing EPS over the last four quarters and increasing year-over-year EPS totals
  • [detail] Increasing net income year-over-year totals
  • [detail] Positive cash flow per share

    • Qualitative Metrics

  • [detail] Consensus analyst recommendation is a buy or strong buy
  • [detail] Understand the company fundamentals
  • [detail] Competent management

Details of my stock valuation checklist

  • [top] Is the stock in a hot sector?

    Where to look
    I typically get new ideas from Jim Cramer and Jim Jubak

    The best stocks in a weaker sector have been known to perform poorly when compared to average stocks in a hot sector. (At the time of writing Agriculture and Energy seem to be what’s in). Try to see/learn where our economy will be heading in the next 5 years.

    As a side note, I completely agree with Cramer on the philosophies of “Buy and homework” as opposed to “Buy and hold.” So do your homework.

  • [top] Earning growth between 15-30%

    Where to look
    Yahoo! Finance > Ticker symbol > Analyst estimates > Grow Est

    Five-year earnings growth between 15% and 30% per year. Companies that exceed a 30 percent earnings growth rate are confronted with two fundamental problems: (1) sustaining a high growth-rate over the long term is extremely difficult; and (2) stocks growing that rapidly are usually already being actively covered by Wall Street analysts.

    That said, I won’t necessarily remove a stock from my research list because of abnormally high growth rates. For example, a large number of energy stocks have well over 100% growth rates in the last 2 years, but they are expected to continue upwards. So if I believe there is growth should I wait until the stock jumps another 20% or get in now? Use the rest of the checklist and decide for yourself. =)

    source: Wikipedia: Stock selection criteria

  • [top] Solid Morningstar Grades

    Where to look
    Morningstar > Ticker symbol > Snapshot

    Financial Health Grade = C or better (prefer A or B)

    Growth Grade = B or better (prefer A)

  • [top] 12-month price target is above the current stock price

    Where to look
    Yahoo! Finance > Ticker symbol > Analyst opinion > Price target summary

  • [top] Earnings growth percentage is higher than its industry

    Where to look
    Yahoo! Finance > Ticker symbol > Analyst estimates > Grow Est

  • [top] Current stock price is above it’s moving average

    Where to look
    Yahoo! Finance > Ticker symbol > Charts (Interactive) > Technical Analysis > Select 50-day moving average

    Moving average is an indicator that shows a stock’s average price over a certain period of time, or basically, its momentum. A 50 day MA is most common.

    The “crossover” principle of moving averages is very important to investing. Whenever a stock price goes below its moving average, that means that it has downward momentum and it is not a good buy. If you have the stock, you should think about selling it. Whenever a stock price goes above its moving average, that means that it has upward momentum and it is a good buy.

    source: Cardinal Money Management: Moving Average

  • [top] Expected return is greater than return on cost of capital

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics

    Using the Capital Asset Pricing Model (CAPM), compare your expected returns with the expected returns of the cost of capital (e.g. the money you are using to purchase this stock). Obviously, you’ll want the most bang for your buck and by factoring in the stock’s risk (e.g. it’s beta) you can figure this out. Here’s how:

    Expected Rate of Return = [RISK-FREE INTEREST RATE] + [STOCK'S BETA] x ([EXPECTED MARKET RETURN] - [RISK-FREE INTEREST RATE])

    So for a stock like MOS, where the beta is 1.17, I could take the 10y T-bill (currently at 3.85% when I wrote this), and plug it into the equation. Assuming a market return of 8% we get:

    Expected return for stock = 3.85 + 1.17(8-3.85)

    = 10.6945


    So if the expected return is higher than 10.69% then it is undervalued and should be taken. If it’s less than 10.69% then it’s overvalued and should not be taken.

    sources: Yahoo! Answers

  • [top] Higher Return on Equity (ROE) than its competitors

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics

    Return on equity shows us how much profit a company earned in comparison to the total amount of shareholder equity on the balance sheet.

    A business that has a high return on equity is more likely to be one that is capable of generating cash internally. For the most part, the higher a company’s return on equity compared to its industry, the better.

    For comparison, the S&P 500 averaged ROE’s of 10 to 15%.

    source: About.com

  • [top] High insider ownership

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics

    Seeing that insiders, employees holding stock or options in the company, have a vested interest in the company’s future performance is another assurance that management believes in future earnings. However I don’t have a specific number etched in stone. GOOG, for example, is under 1%, but that doesn’t mean the stock is a horrible buy. Instead I would say that if you see a large insider stake it’s a good sign, but I wouldn’t hold it against a stock for a low percentage.

  • [top] Institutional ownership of at least 30%

    Where to look
    Yahoo! Finance > Ticker symbol > Summary

    Institutional ownership means that these firms believe they will make money owning this stock. That’s a great thing.

  • [top] Avg daily volume is 100,000 shares or higher

    Where to look
    Yahoo! Finance > Ticker symbol > Summary

    Institutional buying helps drive stock price growth.

  • [top] PEG/YPEG near 1 (or less)

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics

    The P/E and growth ratio (PEG) and the year-ahead P/E and growth ratio (YPEG) are two of most commonly applied metrics of the P/E ratio.

    The PEG essentially compares the current stock price to the company’s annualized rate of growth. For example, if a company is expected to grow at 10% a year over the next two years and has a P/E of 10, it will have a PEG of 1.0.

    P/E of 10
    ———————- = 1.0 PEG
    10% EPS growth

    A PEG of 1.0 suggests that a company is fairly valued. If the company in the above example only had a P/E of five but was expected to grow at 10% a year, it would have a PEG of 0.5 — implying that it is selling for one half (50%) of its fair value. If the company had a P/E of 20 and expected growth of 10% a year, it would have a PEG of 2.0, worth double what it should be according to the assumption that the P/E should equal the EPS rate of growth.

    While the PEG is most often used for growth companies, the YPEG is best suited for valuing larger, more-established ones. The YPEG uses the same assumptions as the PEG but looks at different numbers. As most earnings estimate services provide estimated 5-year growth rates, these are simply taken as an indication of the fair multiple for a company’s stock going forward. Thus, if the current P/E is 10 but analysts expect the company to grow at 20% over the next five years, the YPEG is equal to 0.5 and the stock looks cheap according to this metric.

    Some analysts say fair value is when the PEG is 1.5 or even 2.0.

    source: The Motley Fool

  • [top] Price/Sales ratio less than 10.
    P/S between 3 and 5 for growth
    and below 2 for value stocks

    Where to look
    MSN Money > Ticker symbol > Financial Results > Key Ratios > Price Ratios

    The price/sales ratio takes the current market capitalization of a company and divides it by the last 12 months trailing revenues. The market capitalization is the current market value of a company, arrived at by multiplying the current share price times the shares outstanding. This is the current price at which the market is valuing the company. For instance, if our example company XYZ Corp. has ten million shares outstanding, priced at $10 a share, then the market capitalization is $100 million.

    As with the PEG and the YPEG, the lower the PSR, the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1.0 in order to find value stocks that the market might currently be overlooking. This is the most common application of the PSR and is actually a pretty good indicator of value, according to the work that James O’Shaughnessey has done with S&P’s CompuStat database.

    The PSR is also a valuable tool to use when a company has not made money in the last year. Unless the corporation is going out of business, the PSR can tell you whether or not the concern’s sales are being valued at a discount to its peers. If XYZ Corp. lost money in the past year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2.0 or higher, you can assume that, if it can turn itself around and start making money again, it will have a substantial upside as it increases that PSR to be more in line with its peers.

    A stock with a P/S above 10 is momentum priced.

    source: The Motley Fool

  • [top] Debt-to-Equity (D/E) ratio below 35%

    Where to look
    MSN Money > Ticker symbol > Financial Results > Key Ratios > Price Ratios

    If a company has excessive debt, it is often more difficult to raise additional cash to finance further growth.

  • [top] Increasing revenue over the last four quarters and increasing year-over-year revenue totals

    Where to look
    Yahoo! Finance > Ticker symbol > Income Statement

  • [top] Increasing EPS over the last four quarters and increasing year-over-year EPS totals

    Where to look
    MSN Money > Ticker symbol > Financial results

  • [top] Increasing net income year-over-year totals

    Where to look
    Yahoo! Finance > Ticker symbol > Income Statement

  • [top] Positive cash flow per share

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics (derived from Operating Cash Flow / shares outstanding)

    Companies with positive operating cash flow are safer investments than companies burning more than they bring in.

  • [top] Consensus analyst recommendation is a buy or strong buy

    Where to look
    Yahoo! Finance > Ticker symbol > Analyst Opinion

  • [top] Understand the company fundamentals

    Just as Jim Cramer says… Do your homework! It is imperative that you understand the business model behind the simple dollar calculations. Who are the company’s customers? Suppliers? What factors affect demand for the product? Has the company established a brand? What is the growth strategy?

  • [top] Competent management

    Where to look
    Yahoo! Finance > Ticker symbol > Key statistics

    You’ll want to get an idea for the people running the company as well as track record. Key statistics to look at include return on investment and return on assets.

As I mentioned earlier, I am a fairly new investor. Therefore this checklist is no way encompassing. If you feel I have missed something, or perhaps put too much emphasis on an item already on the checklist please post a comment. Happy investing!