by Charles Rotblut, CFA

There are four key attributes I look for in a stock: an attractive valuation, good financials, a strong business model and the ability to add diversification to my portfolio.

These traits are based on some of the great investment literature that has been written over the past 100 years. For example, Benjamin Graham and David Dodd emphasized the importance of book value in Security Analysis (1934). Philip Fisher stressed the importance of a good business model in Common Stocks and Uncommon Profits (1958). And Harry Markowitz revolutionized portfolio management by showing that diversification can increase returns and lower risk at the same time.

When you combine attractive valuations, strong financials, a good business model and the ability to add diversification, the result is a good risk-reward ratio for a stock.

What is the risk-reward ratio? It is a measure of the probability a stock will decrease in price (risk) versus the probability that a stock will increase in price (reward). The lower the amount of risk and the greater the potential for reward, the higher the probability that the stock will turn into a profitable investment.

To measure a stocks risk-reward ratio, I developed a scorecard for my new book, Better Good Than Lucky (W&A Publishing and Traders Press Inc. 2010), based on these four key attributes. Since investing is messy as opposed to an exact science, I assigned a range of scores for each criterion instead of requiring that a stock meet specific characteristics. It is extremely difficult to find the perfect stock, but there are many stocks that are capable of helping you build wealth. Therefore, the goal is to find stocks whose potential rewards outweigh their potential risks.

The Criteria

Valuation

Price-to-Book Ratio (P/B): The current stocks price divided by book value per share, this ratio shows how many times net asset value a stock is trading at. I prefer a low price-to-book ratio because a well-managed company should not trade at a price near or less than its theoretical liquidation value, or book value. Several studies, as well as data from Ibbotson Associates, show that stocks with low price-to-book ratios outperform stocks with high price-to-book ratios. (Book value, total assets minus total liabilities, is also referred to as equity or shareholders equity.)

Price-Earnings Ratio (P/E): The current stock price divided by earnings per share, this is a measure of how many times trailing 12-month (TTM) earnings a stock is trading at. A high price-earnings ratio can signal that many investors are optimistic about the future, increasing downside risk. (In other words, expectations are too great.) Conversely, a low price-earnings ratio can signal that investors are pessimistic or apathetic, increasing the potential reward should the company announce good news.

Strong Financials

Cash From Operating Activities: Located on the cash flow statement, this is a running scorecard of how much money is coming into and going out of the company based on business operations. (Long-term debt, dividends, stock buybacks and capital expenditures are accounted for elsewhere on the cash flow statement.) Cash flow is useful because there is a difference between earnings and cash. Earnings are an accounting figure, whereas cash flow shows how much a company spends and how much it brings in. A successful business generates cash, instead of burning through it.

Revenues, Net Income and Earnings per Share: A well-run business will have a history of sales and earnings growth. I look at both net income and earnings per share, because share repurchase programs can artificially inflate per share earnings growth.

Current Ratio: Current assets divided by current liabilities (both of which are located on the balance sheet), this is a measure of how liquid a company is. The current ratio calculates a companys ability to meet its current obligations. Companies should have adequate cash levels on their balance sheets, and this can be signaled by a current ratio in excess of 1.0.

Debt-to-Equity Ratio: Long-term liabilities divided by total shareholders equity, this ratio reveals a companys leverage. The larger the number, the greater the claim debt holders can place on assets, among other risks. I prefer this ratio to be no larger than 0.5, though capital-intensive companies may have higher ratios.

Business Model

Return on Equity (ROE) : Net income divided by equity, this is the return management is generating from shareholders equitya proxy for how well a company is run. Since return on equity is impacted by both a companys capital structure and its profit margins, it should be considered within the confines of an industry rather than across industries and sectors. I prefer companies whose return on equity is above that of their industry peers.

Earnings Estimates: Rising profit forecasts suggest business is going better than brokerage analysts previously thought. Conversely, falling earnings estimates suggest the company may be facing a slowdown or other difficulties.

Product Line, Profit and Competition: A good business model will produce products and services that fulfill needs, generate profits and operate in a market with barriers to entry. In other words, you want a company that caters to its customers ongoing needs and does not face intense competition.

Diversification

Portfolio Overlap: Does the stock add to your portfolios diversification? If the answer is no, the stock increases your personal risk level regardless of how strong the other characteristics are.

Discussion

RD Walker from AL posted over 4 years ago:

In Table 1, for the current ratio, the best score is given to a current ratio above 1.0 and below 2.0. Why isn’t the best score for a current ratio above 2.0? Is this a typo, or am I missing something?