What Defines a Good Stock?

Investors will often pour through dozens or even hundreds of stocks looking for the best investment options to add to their portfolios. Before doing this, however, it’s important to first understand what a good stock is.

Let’s take a look at some of the factors that define a good investment to understand what makes a potentially lucrative stock.

Consistent Earnings Growth

Earnings growth is perhaps the single most important factor in making a good stock. Peter Lynch, famous for achieving a nearly 30% annual ROI during his time at the head of Fidelity’s Magellan fund, notably argued that there’s a 100% correlation between long-term stock performance and earnings.

In other words, if earnings triple over a period of time, investors can expect the price of the stock to triple on a similar time horizon.

Revenue growth also plays an important role in helping a stock’s price advance. This is because earnings can only go so high when revenues are stagnant.

At some point, a company will hit the limits of cutting costs and increasing efficiency to promote earnings growth. As long as revenues keep growing, though, earnings have an extra tailwind that can keep them increasing year by year.

Revenue growth is also especially important for businesses that haven’t yet reached profitability. The more revenue growth a company experiences, the more it can eventually realize profits on when it eventually becomes profitable. For this reason, the price-to-sales is a common valuation metric for companies with negative earnings.

The ideal case, of course, is to find a business that is profitable and delivers strong earnings and revenue growth consistently. Rising earnings bolster share prices, while rising revenues make room for further earnings growth.

Strong Balance Sheet

Another very important aspect of a company is its balance sheet. A company with too much debt and not enough cash on hand may be able to do fairly well during good times. When downturns hit, however, a weak balance sheet can put the company in financial peril or even lead to bankruptcy. As such, a strong balance sheet is an essential when looking at a company’s quality as an investment.

One of the key ratios to look for in a balance sheet is the debt-to-equity ratio, which measures total debt against total shareholder equity. Generally speaking, a debt-to-equity ratio above 1 is considered somewhat risky, though there are plenty of companies that successfully manage higher debt loads.

It’s also important to look at the amount of current assets and liabilities a company has. The so-called current ratio measures short-term assets against short-term liabilities to get a sense of a company’s ability to meet its immediate obligations.

A company with a current ratio of over 1 has enough liquid assets on hand to meet these obligations, while one with a ratio of under 1 may be in a more precarious financial position.

Though it may seem like having more cash on hand is always a good thing, investors should be careful to look out for businesses that aren’t deploying their cash effectively.

Too much cash can indicate that a business isn’t investing successfully in new growth initiatives. It can also promote lax spending habits that may potentially reduce earnings in the long run.

Competitive Advantage

One of Warren Buffett’s most famous criteria for selecting stocks is the presence of a strong competitive advantage, sometimes also referred to as an economic moat.

Just as a physical moat keeps unwelcome intruders away from a piece of land, an economic moat prevents competitors from easily coming in and taking market share away from a business.

Economic moats can take several different forms. One of the simplest and strongest is the presence of a dominant brand. Companies like Campbell’s Soup, Coca-Cola, Nike and even Colgate-Palmolive enjoy what are known as brand moats.

Although plenty of alternatives to the products these companies offer exist, consumers will generally go to the brand-name versions due to familiarity and brand loyalty.

In other cases, a moat is created by a company’s own scale. When operating at large scale, a company will usually be able to offer a product or service at a lower cost than its competitors. Likewise, some companies enjoy moats because massive numbers of people use their services, creating what is known as a network effect.

In either of these cases, it’s extremely difficult for a new competitor to enter the market and effectively take customers from already dominant firms.

Market Predictability

Closely related to a company’s competitive advantage is the predictability of its market. A market that is in a constant state of flux is difficult to choose winners in and presents higher levels of investment risk.

A market with predictable dynamics, though, creates the conditions for successful businesses to flourish for years or even decades at a time.

The idea of predictability has been a factor used by many famous stock pickers. Warren Buffett once told Bill Gates that he would stick to chewing gum instead of computers because the internet wouldn’t change the way people chewed gum.

Bill Ackman famously lists predictability among his four characteristics of a great business. While this bias toward predictable businesses seems to fly in the face of the current interest in disruptive technologies and entirely novel markets, its popularity among highly successful investors is well worth noting.

Reasonable Pricing

The final hallmark of a good stock is a price that is either at or below a fair value for the underlying business. Intrinsic value is usually defined as the net present value of all discounted future cash flows a business will produce. For this reason, discounted cash flow analysis is a popular and widely regarded method for valuing stocks.

The ideal case, of course, is to purchase stocks below their fair value. This approach, known as value investing, was pioneered by Benjamin Graham and is largely responsible for the success of Warren Buffett.

In many cases, though, sufficiently good businesses can still be good long-term investments when purchased at fair value.

Interestingly, low enough pricing can turn even otherwise lackluster stocks into decent investments. Buffett himself made his early value investing career in so-called cigar butts, or stocks that were cheap enough to experience a single good rebound even though the underlying business wasn’t performing particularly well.

Likewise, a stock price that is too high can turn even an otherwise incredible business into a losing investment.

What Defines a Good Stock?

A good stock tends to exhibit growing earnings and revenues, a cash-rich low-debt balance sheet, and a wide moat.

Bringing all of these factors together, it would seem that the ideal stock would be one that delivered consistent, reliable growth, had a strong balance sheet, enjoyed a robust competitive advantage in a largely predictable market and was priced at or below its fair value.

Needless to say, such stocks are few and far between. Looking for as many of these characteristics as possible, though, can be a good way to identify productive investment opportunities.

It’s also important to note that different investment strategies may prioritize some of these characteristics over others. Investors focusing on volatile, disruptive tech stocks, for instance, will likely prioritize sheer growth over market predictability and existing competitive advantages.

Those seeking stable income, meanwhile, may be less concerned with high growth rates and prioritize financial health, predictability and market dominance. In most cases, though, it’s best when a stock exhibits several of these characteristics together.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.