The Five Rules for Successful Stock Investing: Morningstar's Guide to Building Wealth and Winning in the Market

by Pat Dorsey

1. Growth: How fast has the company grown, what are the sources of its growth, and how sustainable is that growth likely to be?

2. Profitability: What kind of a return does the company generate on the capital it invests?

3. Financial health: How solid is the firm’s fi...

4. Risks/bear case: What are the risks to your investment case? There are excellent reasons not to invest in even the best-looking firms. Make sure you look at the full story and in...

5. Management: Who’s running the show? Are they running the company for the benefit of s...

You can’t just look at a series of past growth rates and assume that they’ll predict the future—if

High-quality growth that comes from selling more goods and entering new markets is more sustainable than low-quality growth that’s generated by cost-cutting or accounting tricks.

sales growth stems from one of four areas: 1. Selling more goods or services 2. Raising prices 3. Selling new goods or services 4. Buying another company

Comparing cash flow from operations to reported earnings per share is another good way to get a rough idea of a firm’s profitability because cash flow from operations represents real profits.

Return on Assets (ROA) You already know the first component of ROA. It’s simply net margin, or net income divided by sales, and it tells us how much of each dollar of sales a company keeps as earnings after paying all the costs of doing business. The second component is asset turnover, or sales divided by assets, which tells us roughly how efficient a firm is at generating revenue from each dollar of assets. Multiply these two together, and you have return on assets, which is simply the amount of profits that a company is able to generate per dollar of assets.

Return on assets = Net margin × Asset turnover, ROE in all its glory equals: Net margin × Asset turnover × Financial leverage

Free cash flow = Cash flow from operations—Capital spending

Essentially, ROIC improves on ROA and ROE because it puts debt and equity financing on an equal footing: It removes the debt-related distortion that can make highly leveraged companies look very profitable when using ROE. It also uses a different definition of profits than ROE and ROA, both of which use net income. ROIC uses operating profits after taxes, but before interest expenses. Again, the goal is to remove any effects caused by a company’s financing decisions—does

divide the management-assessment process into three parts: compensation, character, and operations.

Compensation is the easiest of the three areas to assess because the bulk of the information is contained in a single document, usually called the proxy statement.

Here’s what to look for in a company’s compensation plan. First and most important, how much does management pay itself?

The bottom line is this: Executives’ pay should rise and fall based on the performance of the company.

look for a section called “related-party transactions.” If a friend or relative of a company officer has substantial business dealings with the firm, you’ll read about it here.

Is the Board of Directors Stacked with Management’s Family Members or Former Managers? Look at the biographies of the board,

I especially like to look at the letter to shareholders in the annual report. Is it a candid assessment of the past year’s successes and failures or a fluff piece?

Does Management Make Tough Decisions that Hurt Results but Give a More Honest Picture of the Company? If a management team makes decisions that actually hurt reported results, you’re in luck.

Make sure the company discloses enough information for you to properly analyze the business. “We don’t disclose that” is often code for, “The news is bad, so we’d rather not say.”

When a company produces more than it’s selling, either demand has dried up or the company has been overly ambitious in forecasting demand. In any case, the unsold goods will have to get sold eventually—probably at a discount—or written off, which would result in a big charge to earnings.

if a firm suddenly decides that an asset has a longer useful life and stretches out the depreciation period, it’s essentially pushing costs out into the future and inflating current earnings.

Any time you see expenses being capitalized, ask some hard questions about just how long that “asset” will generate an economic benefit.

The simplest way to detect aggressive accounting is to compare the trend of net income with the trend in cash flow from operations. If net income is growing quickly while cash flow is flat or declining, there’s a good chance of trouble lurking.

Watch the trend of accounts receivable relative to sales. If accounts receivable is growing much faster than sales, the company may be having trouble collecting cash from its customers.

Pension income and gains from investments can boost reported net income, but don’t confuse them with solid results from the company’s core operations.

Investors purchase an asset for less than their estimate of its value and receive a return more or less in line with the financial performance of that asset. Speculators, by contrast, purchase an asset not because they believe it’s actually worth more, but because they think another investor will pay more for it at some point.

The return that investors receive on assets depends largely on the accuracy of their analysis, whereas a speculator’s return depends on the gullibility of others.

Vanguard founder John Bogle has pointed out, the investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth,

the speculative return comes from the impact of changes in the price-to-earnings (P/E) ratio.

When you use a PEG ratio, you’re assuming that all growth is equal, generated with the same amount of capital and the same amount of risk.

The nice thing about yields, as opposed to P/Es, is that we can compare them with alternative investments, such as bonds, to see what kind of a return we can expect from each investment.

Don’t rely on any single valuation metric because no individual ratio tells the whole story. Apply a number of different valuation tools when you’re assessing a stock.

If the firm is cyclical or has a spotty earnings history, use the price-to-sales ratio. Companies with P/S ratios lower than their historical average can sometimes be bargains.

Check the earnings yield and cash return, and compare them with the rates available on bonds. An earnings yield or cash return above current bond rates can indicate an undervalued stock.

If I could buy the whole company, what would I pay?

The value of a stock is equal to the present value of its future cash flows. No more and no less.

A present value calculation simply adjusts those future cash flows to reflect the fact that money we plan to receive in the future is worth less than money we receive today.

Why are future cash flows worth less than current ones? First, money that we receive today can be invested to generate some kind of return, whereas we can’t invest future cash flows until we receive them. This is the time value of money. Second, there’s a chance we may never receive those future cash flows, and we need to be compensated for that risk, called the “risk premium.”

not many cash flows are as certain as those from the feds, so we need to tack on an additional premium to compensate us for the risk that we may never receive the money that we’ve been promised. Add the government bond rate to the risk premium, and you have what’s known as a discount rate.

Discount rates are really just interest rates that go backwards through time instead of forwards.

As interest rates increase, so will discount rates.

The key is to pick a discount rate you’re comfortable with. Don’t worry about being exact—just think about whether the company you’re evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you’ll be fine. In addition, remember that assigning discount rates is an inexact science—there is no “right” discount rate for a company.

Any valuation and any analysis is subject to error, and we can minimize the effect of these errors by buying stocks only at a significant discount to our estimated intrinsic value. This discount is called the margin of safety,

Estimating an intrinsic value keeps you focused on the value of the business, rather than on the price of the stock.

Stocks are worth the present value of their future cash flows, and that value is determined by the amount, timing, and riskiness of the cash flows.

A discount rate is equal to the time value of money pl...

The risk premium is tied to factors like the size, financial health, cyclicality, and competitive position...