The Five Key Factors that I Consider in Stock Investments

by Chris Parsons

Today is Part II of the four part series I’m doing on investing. See Part I for why I pick stocks instead of indexes.

I love stocks. I love that I have the ability to make a judgment call and be accountable for the results. I really love that money I invest in stocks has the ability to compound over many years. Investing in stocks is like starting a company – except without all the hard work.

There are five factors that I consider when deciding whether or not to buy a stock:

Price of stock
Price Return of Investment - aka Dividend
Financial Position of Company
Future business analysis
Company size and popularity

The single most most important factor in investing in stocks is Price. It doesn’t matter how great of a business it is or how high the dividend is IF YOU OVERPAY FOR THE STOCK. The easiest way to measure the price is via the P/E Ratio, which historically is about 17, and is higher during booms & lower during recessions. Therefore, any investor should be weary of P/E Ratios higher than 17. The better the business, the higher the P/E I’m willing to pay, as it should be, but I don’t invest in companies with a P/E Ratio above 25 – and I typically stay under 20.

Ah, the glorious dividend… the best way to compound your money for future growth. A dividend is when a company pays you to own their stock. The dividend yield is determined based on the current stock price and annual dividend amount. Dividends should be sustainable (based on payout ratio), and show a history of growth. After all, if the company doesn’t increase or continue the dividend – it is not helpful to you as an investor. But if they do, and you reinvest the dividends, you can create a nice passive income stream in the future.

The company must make enough money to support continuing to pay the dividend – this is what I mean by sustainable. Other financial indicators are also important. Long-term debt to Equity ratio is something that I pay a good bit of attention to because leverage usually means risk. I’d prefer very little debt for companies, but there are times when it is appropriate. I also review trends for operating margins, etc to get a good picture of the business.

75% of the stocks that I buy are for investment horizons of at least 10 years. Therefore, in order for the stock to increase, the business must grow and prosper for at least that long. When evaluating a business, you have to consider the competition, the political landscape, management’s capabilities, and many other things.

The other 25% of the stocks that I buy are more speculative in nature. For instance, clearly mis-priced stocks which I believe will go up over the next year or two. Even with these investments, my timeline is always > 1 year. It doesn’t make financial sense to trade more often than this, as the fees eat my returns away (my typical investment is currently under $1k). In these cases, I’m not particularly concerned about the businesses’ long-term future.

Company size and popularity is a bit of an odd choice, but they are important. By company size, I mean Market Cap. I prefer small cap stocks, but do have some ”blue chip” large cap stocks and keep a good mix of the two in my portfolio. By popularity I mean the number of people investing in a stock, as well as the number of analysts following it. For instance, Apple (maker of the computers, iPods, iPhones, etc) has 50 full-time professionals that analyze the stock. The chances of me being better than them is very slim. There are also a ton of amateur stock-pickers who have Apple and Google as their “hot” stock picks. The only way that I can beat the crowd is by not following what they do, and so – I don’t.

PS: I use Motley Fool & Yahoo! Finance to review these factors.