My 5 Criteria for Stock Evaluation

How do we determine if a stock is worth to be included in our portfolio? This is a question that you yourself must find your own answer. Nonetheless, I will share my opinion here for your reference.

After passing the preliminary screening (e.g. good profitability, consistent profit margin, regular dividend, etc.), I will use the following five yardsticks to see if I should buy the stock or not.

 

Dividend yield (DY)

First criterion is DY. It is related to the dividend doled out by the company.

Quoting Investopedia,

“A financial ratio that indicates how much a company pays out in dividends each year relative to its share price. Dividend yield is represented as a percentage and can be calculated by dividing the dollar value of dividends paid in a given year per share of stock held by the dollar value of one share of stock. The formula for calculating dividend yield may be represented as follows:

(Investopedia Definition Link)”

DY is the percentage of dividend that we get in a given year compared to the share price we paid. What I aim for is at least a 5% DY annually. The share price that I calculate is the average between its highest and lowest price for that year.

 

Cash ratio

Second attribute is its cash ratio. This is related to the cash and current liabilities.

From Investopedia,

“The cash ratio is the ratio of a company’s total cash and cash equivalents to its current liabilities. The metric calculates a company’s ability to repay its short-term debt; this information is useful to creditors when deciding how much debt, if any, they would be willing to extend to the asking party. The cash ratio is generally a more conservative look at a company’s ability to cover its liabilities than many other liquidity ratios because other assets, including accounts receivable, are left out of the equation.

(Investopedia Definition Link)”

This ratio takes into account the cash on hand to pay off the short-term liabilities. For this criterion, I require a minimum of 0.5. This means that the company has enough cash to clear off half of its short-term debts.

 

Current ratio

Third criterion is current ratio. It is related to the current assets and current liabilities of a company.

According to Investopedia,

“The current ratio is a liquidity ratio that measures a company’s ability to pay short-term and long-term obligations. To gauge this ability, the current ratio considers the current total assets of a company (both liquid and illiquid) relative to that company’s current total liabilities. The formula for calculating a company’s current ratio is:

Current Ratio = Current Assets / Current Liabilities

The current ratio is called “current” because, unlike some other liquidity ratios, it incorporates all current assets and liabilities.

The current ratio is also known as the working capital ratio.

(Investopedia Definition Link)”

This ratio measures the ability of the company to pay off its short-term liabilities with its current assets. My target for this criterion is 2. This means that the company has twice the current assets of its current liabilities.

 

Debt/equity (D/E) ratio

My fourth attribute is D/E ratio. This ratio scrutinizes debt incurred and equity of the company.

From Investopedia,

“Debt/Equity (D/E) Ratio, calculated by dividing a company’s total liabilities by its stockholders’ equity, is a debt ratio used to measure a company’s financial leverage. The D/E ratio indicates how much debt a company is using to finance its assets relative to the value of shareholders’ equity. The formula for calculating D/E ratios is:

Debt/Equity Ratio = Total Liabilities / Shareholders’ Equity

The result can be expressed either as a number or as a percentage.

The debt/equity ratio is also referred to as a risk or gearing ratio.

(Investopedia Definition Link)”

Nonetheless, contrary to the above definition, I only consider both long-term and short-term debts, instead of the total liabilities. Normally, the lower this ratio is, the better it is. Thus, there is not a hard target for this ratio.

 

Free cash flow (FCF)

The last criterion is FCF. Cash flow is a very important part of a business.

According to Investopedia,

“Free cash flow (FCF) is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

(Investopedia Definition Link)”

For FCF, we need to check both the cash flows from operating activities and cash flows from investing activities in the financial statements. I will aim for positive value for this criterion. A positive value means the company is generating instead of burning cash.

 

End

All these targets are set arbitrarily by me. Sometimes, if I deem a company to have great potential, I might buy it even though it does not hit all the criteria. Nonetheless, this only happened infrequently.

These are my criteria to evaluate the attractiveness of a stock. So what will your criteria be?