So far, I’ve settled upon 6 main criterion to look for in stocks before considering their valuations:
1. Net Income growth consistency
A growing business is one of the most important factors to look for in any business. I’ve previously considered using EPS instead but I realised that there are times whereby EPS was inconsistent due to variances in shares outstanding, which has no relation to the profitability of the business. Another figure I’ve considered was Revenues but only considering revenue neglects the cost of running the business, which will also affect profitability.
2. FCF growth consistency
I strongly believe in the saying that “cash is king” for a business. FCF takes into account the cash generating ability of a business and also its profitability. HOWEVER, I have been constantly reminding myself that lower or negative FCF may not necessarily be a bad thing since it could be a result of large investments by companies. In general, I wish not to hold too many of companies making large investments that require a long time to mature. I very much prefer to receive these excess cash in dividends that I can use to compound my investments.
3. Debt/FCF < 5
Having debt in a business is not necessarily bad but the ability to pay off the debts must be considered. The Debt/Equity ratio however was not suited for this purpose since it is unlikely for a long lasting business to sell off assets to repay debt. Instead, I consider how long a company would take to repay debt if they paid off the debt with all their FCF. For this calculation, an acceptable threshold for me would be a 5 year time horizon (i.e. if we took all the companies FCF to pay off debts and if the company can pay off all debt under 5 years, the company has strong financial abilities).
4. Dividend yield size
As mentioned earlier, I find dividends to be a great source of income. For me, it serves as a great source of funds for compounding my investments. Also, I believe that businesses that provide dividends are tend to be financially sound (of course there are exceptions, such as Alibaba, which currently consists of 40% my portfolio as of this writing). But rest assured that I will still consider businesses that do not give out dividends as long as the other requirements are met and the valuations are right. And of course, the higher the dividend, the better for me. HOWEVER, the dividend yield has to be compared with the FCF yield to calculate the ability of the company in paying dividends just from their cash flows. Consider if dividend yield > FCF yield, then we have to ask the question of how the business is sustaining such a high dividend yield at all (perhaps through debt?).
5. Dividend growth consistency
Dividend growth, likewise, is also a reflection of the business’ financials. Long periods of consistent dividend growth is likely to be replicated in future and would spell good news for me as an investor.
6. Dividend payout ratio < 60%
This ratio determines how much of net income is used to pay dividends. In general, although I’d like to have as much of the net income as dividends for myself, I believe that any company who wishes to grow would like to retain much of its earnings to be reinvested for future growth. (NOTE: This is NOT contradictory to what I mentioned earlier. I want companies with high dividend yield but not too high payout ratios.) A high dividend payout ratio could mean that the business is overpaying dividends just to look as if its dividend has been growing steadily. This comes at the cost of the available capital for the company’s growth.
These 6 criteria only serve as a guide to my stock picking process and are still currently work-in-progress.