Ask HN: How do you evaluate Stocks?

I evaluate stocks in 3 steps:

Step 1. Look At The Numbers

First of all I have a look at a company’s balance sheet.

When I am looking at a company’s balance sheet I am using the Current Ratio and Acid Test Ratio to assess its liquidity, looking at its Long Term Liabilities (in particular I’m looking at if they are growing at a faster rate than assets), its Debt-To-Equity Ratio and its book value.

If they look good then I will have a look at the company’s income statement.

The first thing I look at is its Earnings, COGS, EPS and ROE (I also calculate the P/E Ratio and PEG Ratio)

Step 2. Look At The Competitive Advantage

I assess the company’s competitive advantage in particular; I have a more in-depth look at it to see if the company has a large enough advantage to keep its stay above the competition and benefit from the increasing profits.

Step 3. Look At The Company’s Culture/Integrity

Finally, I look at the company’s culture and its integrity. I’m interested in company’s who have a strong company culture and are interested in creating long-term shareholder value.

Funny, I wrote a note explaining my process a couple of days ago..

1. What is the business, do I understand it? (If no, then less likely to buy)

2. Numbers (revenues, earnings, margins) over the last 5 years atleast

3. Piotroski score -- more of a shortcut to quickly assess quality of the business

4. Annual price returns -- more to understand how the stock has been doing over the years and over the last few months

5. Liquidity/debt ratios -- this is very industry driven, some sectors like tech have very low debt levels others have higher

6. Comparables -- steps 2 to 5 for atleast one or two direct competitors. Plus ratios ofcourse (PE,Price to Book, EV/EBITDA etc)

7. A very quick dcf -- (I've been building a tool that helps me do this quickly)

If I've done all these steps (takes me about 30 - 40 minutes to do these steps), and I like the company then read the annual report (at-least twice).

Often takes me a couple of weeks if not more to decide to initiate a long position.

blog post -- http://equisear.ch/blog/2013/04/the-first-30-minutes-looking...

I've been building tools that help me do this, its not ready yet but gets me there most of the way-- http://equisear.ch

Piotroski Scoring is a quick way to evaluate stocks. You score one point if a stock passes each test and zero if it doesn’t. The maximum score is nine.

1.) Net Income: Bottom line. Score 1 if last year net income is positive.

2.) Operating Cash Flow: A better earnings gauge. Score 1 if last year cash flow is positive.

3.) Return On Assets: Measures Profitability. Score 1 if last year ROA exceeds prior-year ROA.

4.) Quality of Earnings: Warns of Accounting Tricks. Score 1 if last year operating cash flow exceeds net income.

5.) Long-Term Debt vs. Assets: Is Debt decreasing? Score 1 if the ratio of long-term debt to assets is down from the year-ago value. (If LTD is zero but assets are increasing, score 1 anyway.)

6.) Current Ratio: Measures increasing working capital. Score 1 if CR has increased from the prior year.

7.) Shares Outstanding: A Measure of potential dilution. Score 1 if the number of shares outstanding is no greater than the year-ago figure.

8.) Gross Margin: A measure of improving competitive position. Score 1 if full-year GM exceeds the prior-year GM.

9.) Asset Turnover: Measures productivity. Score 1 if the percentage increase in sales exceeds the percentage increase in total assets.

How Professionals do it: Bloomberg subscription ($1500/month) + CapIQ ($1000/month) + sell-side equity research reports + industry-specific research reports + excel add-ins + network of management, friends. They know exactly how their valuations differentiate from other professionals'.

How we do it: Talk about ratios, try and read articles, etc.

I will share my experience which is very anecdotal. I am not big into stocks etc. but one of the companies I highly admire is MACYS (M). Simply because I am a long time happy customer, their products/service including customer service has been excellent in my experience and they always seem to be doing smart business. Liking the company so much, I bought about 5 stocks back in 2008 (i think!!) for about $20 each. Today, stock is worth $40+. If only I bought a lot more :)

Anyway, i m not expert but it will surely help if you actually understand the company which usually means you are their customer, see how they do business, does it seem like they actually give a damn about their business and how far do they go to retain customers and keep them happy ? For me, those are plus points. The numbers like price, P/E etc. all seem like , well, just numbers to me.

I look at companies that I know well, mostly companies I deal with directly either as a customer, partner, employee, that way you get news first hand and no bad surprises. Company numbers are easily manipulated and financial news have their agendas and interests (different from yours).

From my accounting background, some common ratios I use:

1) acid ratio (liquid assets / short term liabilities)

2) gross operating margin

3) net operating profit margin

4) return on capital/equity

5) return on balance sheet assets

I also compare the stock in question to other bonds and stocks of other companies similar in size or industry. This is just to see if the company is managing its money well in relation to other companies.

Finally, tax consequences of sale. The conventional wisdom of market returns of 11% (US treasuries + 8% * portfolio beta , 1.0 for market portfolio) loses its appeal if your tax bracket is sufficiently high (i.e. software engineer in California) .

Intuition. I used to trade using pure intuitive signs: http://i.imgur.com/rFSVa8P.jpg

Go and read the Intelligent Investor by Benjamin Graham, then read Security Analysis by the same author.

What could be its future earnings? What is its price now? Lower the P/E the better it is.

Very badly.