The 4-Step Formula to Picking the Best Stock Investments

Here at The Fifth Person, we use a 4-step formula to analyse all our stock investments.

We call it The Investment Quadrant. As the name suggests, there are four quadrants to The Investment Quadrant – Business, Management, Financials and Valuation.

Before we invest a single dime in any stock, we always run it through The Investment Quadrant to make sure the company passes all our minimum criteria and benchmarks. This way you know that the companies that do pass the test are the some of the best stock investments around and have a high degree of certainty of being profitable in the long run.

Now you may or may not already know about the Quadrant as we’ve mentioned it before from time to time in some of the analyses we share on our site. And since we’re going to use it a lot more in our future analyses, we’re going to describe The Investment Quadrant in more detail in this article so you can always refer here again whenever it’s needed.

So let’s get started!

The Business Quadrant

In the Business Quadrant, you need to analyse the business model of a company and how it generates its revenues and profits. A company with a superior business model simply has a more secure, stable and efficient way of making money.

In other words, this company is able to generate more revenue and profits with more predictability for a long time to come. What do think that’s going to do to its share price?

Besides evaluating and understanding a company’s business model itself, there are three other areas you need to consider as well:

• Growth drivers. Does the company have any ways to grow and expand its business? A company with strong growth drivers has more potential to generate more revenue/profit and drive its stock price higher. A company with no growth prospects will simply remain stagnant.
• Economic moat. Does the company have a strong competitive advantage? Competition is fierce where there are profits to be made and a company needs to be able to defend its turf and continually stay ahead of its competition. If not, a once thriving business could be wiped out overnight – just take a look at what happened to BlackBerry when the iPhone came along.
• Risks. What are the potential risks that a company might face? Serious risks are anything that can harm a company’s revenue and profits permanently, and in the worst case scenarios, cause a company to go bankrupt. A company with fewer risks simply has lower chances of going down and higher chances of success.

The Management Quadrant

A company’s top management team consists of the CEO, C-level executives, and the board of directors. They’re responsible for the leadership, direction, and overall growth of the company.

Good management can lead a company to higher revenue, profit and growth while also contributing back to society in positive ways. Poor management can bring a company down, sometimes toward bankruptcy, destroying shareholder value in the process.

Just like how Apple became the tech behemoth today based on Steve Job’s legendary vision and leadership, you need to pick companies with a CEO and management team that can lead a company (and its stock price) to greater heights.

Besides the talent of a company’s management team, you also need to consider how aligned they are with shareholders’ interests. Management that is aligned will protect the value of your investment and not undertake actions that would harm the interests of shareholders.

The Financials Quadrant

This is the quadrant that most novice investors focus exclusively on, simply because it’s easy to analyse a company when you have hard data like numbers to examine.

While financial performance is extremely important and ultimately indicates how successful a company is, you can’t analyse a company based on financials alone.

A company’s qualitative aspects like its business model and management team are just as, if not more, crucial to its long-term success.

With that said, here is (but not an exhaustive) list of items you need to look at when analysing a company’s financials:

• Does the company have a track record of rising and consistent revenue and profit? A successful and growing company should see growing revenue and profit.
• Is the company able to maintain a good level of gross and net profit margins? Eroding margins might signal that a company’s business fundamentals are deteriorating.
• Does the company have a track record of rising and consistent cash flow? Cash flow is extremely important because a company needs cash to continue operating its business. A profitable company can go bankrupt if it manages its cash flow badly and runs out of cash.
• Does the company have a healthy amount of cash in the bank? Just like how we need a certain amount of savings in case of a rainy day, a company needs some cash in case it unexpectedly runs into difficult times. Too much cash however and it could mean that the company has problems deploying it for business growth and investments.
• Does the company have low, manageable levels of short-term and long-term debt? The higher the debt, the more risky is is. Take a look at a company’s current ratio and debt-to-equity ratio.
• Is the company able to generate good returns for its shareholders? Take a look at a company’s return on equity and return on assets ratios.

If you’re interested to know more, we teach more about financials and key ratios in our Investment Quadrant online training course.

The Valuation Quadrant

Finally, even if a company passes the first three quadrants, you still need to accurately determine a stock’s intrinsic value to know if it’s currently undervalued or overpriced. Even if a company is  a great business to start off with, overpaying for its stock makes it a bad investment.

The best way to make money in a stock investment is knowing that you’re getting a good deal in the first place. Just like buying a million-dollar home for only half of that – you want to purchase a $100 stock for only $50. You can’t help but profit when you make a good investment at the right price.

There are many ways to value a stock including P/E ratio, PEG ratio, P/B ratio, the discounted cash flow model, etc. They all work – but the important thing is to use the right valuation method for the right type of company in the right business situation. We cover more on that in our Investment Quadrant training course.

There you have it.

The four steps we personally use when it comes to analysing our stock investments. It’s worked amazingly well for us and we hope The Investment Quadrant will also help you make better investments and profit further in the stock market pretty soon in time to come!

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