Hi guys! I’ve had many requests over the last few weeks to do a video explaining how to analyse a stock before investing. A lot of people who watch my videos are complete beginners ( I’m making this assumption from the emails and messages I get!) so I wanted to share with you what I’ve learnt so far in my journey, and how I pick what stocks to invest in – but also enlist the help of a friend, who is far better versed in this universe than I am. We’ve made this video and article together, so please do also check out his channel and make sure to subscribe – you won’t regret it – I have linked both of our channels at the bottom of this article. I absolutely love his videos, graphics and brilliant analysis videos. This article is mostly a script from the video so if you would like to follow along with the explanations please watch the video embedded below!
Ben and I are both dividend investors, so most of the analysis here will focus on dividend paying stocks, rather than value investing.
DISCLAIMER – Any advice given on my channel, blog and videos is for information purposes only, and does not act as financial advice. Your financial decisions are your full responsibility, and if you are in any doubt, please contact a Finance adviser before undertaking any investment with your money or change to your financial activities.
Risk tolerance (Anna)
Personally, I think the first question you need to ask yourself is how much risk do you want to take on with each investment. Any investments you make put your money at risk – please don’t ever forget that. There are investments that are safer, but there is never a 100% guarantee. As mentioned in the disclaimer, if you don’t feel comfortable making your own financial decisions, it may be worth talking to a financial advisor ( and I mean a qualified one, not a “money coach” from instagram). I have nothing against money coaches, but there is a difference between someone offering an opinion and guidance, and someone giving actual investment advice based on your individual circumstances.
If you want to stay super safe, it is worth sticking to things such as ETF’s where your money is spread across tracking a basket of stocks rather than an individual company.
With my portfolio, it is a mixture of ETFs and individual stocks. I have personally chosen to invest in ETFs that focus on the S&P 500 companies (largest companies in America) and the FTSE100 (largest companies in the UK). You can also choose ETFs based on industries, for example you can invest in an ETF that focuses primarily on companies in the technology sector etc.
The rest of this article will focus on choosing individual stocks, should you wish to do so.
Valuation & growth (Ben)
Number 2, when I invest in a company, I always look at the growth rate and valuation. When I talk about growth, I am talking about how quickly the company is growing its earnings, free cash flow, sales, and book value or assets. I want to see that company is making more and more money and becoming more valuable. How fast the growth needs to be really depends on a lot of factors. For example, how fast are the rivals of the company and the company’s industry growing? If most companies in the industry are growing at 5% annually and this company is growing at 15%, that is excellent.
I want to see the company has consistently grown over time and I also look at how it grew during prior recessions. Regarding growth, I look at the price of the company compared to their earnings, book value, free cash flow, sales, and EBITDA. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Basically, I want to get as much of these things as I can for every dollar I invest. A low price to earnings ratio, for example, means I am getting more earnings from the company for each dollar I invest.
The price to earnings ratio is literally the price divided by earnings. If a company’s shares are selling for $10 and the company’s earnings are $1 per share, the price to earnings ratio is 10/1 or 10. I have an entire video explaining the price to earnings ratio if you want to learn more and it is linked in the description below. In short, I would rather get $2 in earnings per year for a $10 investment than only 50 cents in earnings. How high or low I want these ratios to be will depend on that company’s historical valuation, the valuation of its rivals and industry, and the expected growth of the company.
Dividend cover / payout ratio (Anna)
Dividend cover tells you how many times the company can pay its current level of dividend, so essentially tells you how sustainable the current dividend is.
Generally speaking, you would want to see a dividend cover of 2 or more, as this is what’s considered “safe” in the financial world. Anything lower can actually mean that the company will struggle to cover its dividends in a bad trading year.
The higher the cover, the more unlikely it is that the dividend will fall the following year – important if you are looking for consistent passive income in the future! If a company’s dividend coverage ratio is less than 1, it might be borrowing funds to pay dividends, which is a bad sign!
Most trading platforms and websites will now calculate a lot of these ratios for you, but essentially dividend cover is calculated as
(Profit after tax – dividend paid on preference shares) / dividend paid to ordinary shareholders
A different way of looking at this is to have a look at the stock’s payout ratio. This basically tells you how much of the company’s income is going toward dividends. A payout ratio that is too high — (compared to other companies in the same industry) means the company is putting most of its income into paying dividends. If the payout ratio is over 100%, the company may be going into debt to pay out dividends, which is a huge red flag! A good example of a stock which would have a high payout ratio is a REIT – they are mandated to pay out 90% of their profits as dividends.
Dividend yield (Ben)
Next, we have dividends. I am a dividend growth investor and thus dividend yield and growth is very important to me. I want to invest in companies which are paying out a decent amount every month or quarter in dividends but are also growing those dividends quickly. As the dividend payments are increased by the companies and I reinvest them, my returns compound rapidly. One metric that combines both the dividend yield and dividend growth is the Chowder number.
The Chowder number is simply the sum of the current dividend yield plus the five-year annual dividend growth rate. If the dividend yield is under 3%, we ideally want the dividend growth rate to be at least 12% which would give us a Chowder number of 15 given 3+12=15. If the dividend yield is greater than 3%, we should expect slower growth. We therefore want at least a Chowder number of 12. We are willing to accept a slower growth rate because we are receiving a higher dividend yield. So, as an example, a 5% yield which grows at 2% is a chowder number of 7 and is too low for an investment. A company with a 4% yield which is growing at 9% has a chowder number of 13 and meets the criterion.
Personal interest in the company (Anna)
You might not see this in your standard “what to look out for” videos. But for me, one of the things I consider when deciding on whether I want to invest in a stock, is my own personal interest in the company. Don’t get me wrong – I have mostly invested in companies which I haven’t got much interest in, but I know cover everything else I look for and are likely to do well. But there are some stocks, where I just invest because I believe in the company – if you’ve watched my Freetrade portfolio you will see that I’ve invested in Gregg’s (a UK bakery) because I absolutely love some of their new vegan products and I think they will do even better when they bring out more in the range. Of course, investments like this are more risky – but to me, I am personally ok with accepting this level of risk and it also adds a little bit of fun to investing.
Company assets & liabilities position (Ben)
For #6, I always consider a company’s liabilities or debt. A company with too much debt may be unable to pay for it. If a company cannot pay for its debt, it may have to sell off part of the company, issue more shares which drops the share price, and/or go into bankruptcy. These options are all bad for us as the shareholders and will hurt our long-term returns. I would prefer companies I invest in can pay out their cash to shareholders or reinvest that money back into the company rather than paying off interest. I look for companies with low debt when compared to its assets and equity. I make sure the company I invest in can pay for its debt and the interest, and I check whether the company’s debt has been increasing or decreasing. I want to buy companies which are reducing their debt over time.
A Company Moat (Anna)
This is a really important thing to consider when investing your money. Think of a traditional moat – it’s what protects a castle from intruders. Well, a moat in the investing world, essentially means the long term competitive advantage of a company against its competitors.
There is no formula to calculate these, but it is usually obvious if a company has a moat advantage in a particular area – for example, if you think about Google – do you really see any other company overtaking this giant any time soon? I don’t.
For example, is it the only company that can provide a certain service? Does it have a significant brand advantage, which allows it to charge more for its services ? Does it have patents which mean other competitors cannot replicate the very thing that is bringing in profits (e.g. drug companies!).
A company may have huge economies of scale, which allow it to bring down its costs significantly over competitors.
Ability to understand the company (Ben)
It is important that we only invest in companies that we can understand. If you invest in a company that specializes in acquisition, recapitalization, mezzanine debt, restructurings, rescue financing, and leveraged buyout transactions of middle market companies, do you have any idea what that means? If the Fed raises interest rates, is that good for your investment? If you hear the market price of securities issued by your investment have increased, is that good? Is it bad? If you can’t answer these questions, this is a company you don’t understand. It’s too complicated and you are unfamiliar.
There is nothing wrong with not understanding that company as long as you don’t invest in it without knowing what will affect its success and your returns. If you are better able to understand what McDonalds does, then that might be a better investment for you because you can more easily predict it, understand why the price is rising or falling, and ultimately decide when to buy or sell.
Hopefully that is somewhat helpful and that you have more of an idea on how to analyse a stock before investing your hard earned cash – don’t forget to subscribe to both of our channels – link to the video below!
Ben’s Stock Investment Analysis channel: https://www.youtube.com/channel/UCPuoPykmbEx5nk-9UASO_tg