4 Things You Need to Know Before You Buy

Here's the picture: You've been keeping up with a list of stocks via your Foolish watchlist (more on that later) and you decide that it may be a good time to put a little more of your cash to work now that the S&P 500 has fallen considerably from its mid-February high.

But when it comes down to pulling the trigger, how do you choose which stock gets the nod?

Having the following four pieces of information close at hand can help you make that call.

1. Expected returns. This is the elephant gun in the mix because it combines four key pieces of the investment puzzle -- earnings growth, valuation, dividends, and share count -- to give you an expected return on the stock in question. In the process of determining expected returns, I think the best strategy is to find a range of possible outcomes, but for the purposes of making the final buy decision, have your mid-case (most likely) scenario at hand.

Curious how to determine expected returns for the companies on your watchlist? I've walked through the process for both Sysco (NYSE: SYY  ) and Raytheon (NYSE: RTN  ) .

2. Insider ownership. Motley Fool co-founder Tom Gardner once said that if he had to choose a single metric to judge a stock on, it'd be insider ownership. Fortunately, we're not limited to just one metric, but Tom's bold statement underscores the importance of this one. Put simply, a CEO who owns a hefty amount of the company's stock very likely has incentives that are aligned with you and the other investors.

With a company like Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) -- where Warren Buffett owns roughly 20% of the company (worth a cool $50 billion) -- the ownership connection jumps out as obvious. That size of a percentage stake, however, is more common among smaller companies -- CEO Maryjo Cohen, for instance, owns nearly 25% of National Presto Industries (NYSE: NPK  ) .

For larger companies, a CEO's incentives can still be aligned with yours without a huge percentage ownership. Lloyd Blankfein over at Goldman Sachs (NYSE: GS  ) owns less than 0.5% of the company, but that still translates to more than $300 million in stock -- and that doesn't include stock options or restricted stock.

3. The Buffett ratio. There are many ways to measure the efficiency and profitability of a company, but I've fallen for this measure. Referred to by Buffett as "earnings on unleveraged net tangible assets" in his Berkshire shareholder letter this year, this is a measure similar to return on equity or return on invested capital.

Why this particular ratio? Because it emphasizes returns on all of the capital that the company is using -- rather than just the equity -- but it strips out the company's intangible assets, which is generally more of an accounting artifact than useful measure.

4. The special sauce. Call it a competitive advantage, call it a moat, call it whatever you want -- this is what gives the company in question a leg up over its competition. Moats come in all shapes and sizes -- some wide and nearly impossible to breach, while some are pretty shallow -- but if you're planning to buy into a company, you ought to know what makes it special.

For example, in the case of Coca-Cola (NYSE: KO  ) it has -- at least according to brand expert Interbrand -- the most valuable brand in the entire world. That is a seriously formidable moat for any upstart cola-maker that wants to try to unseat the king.

Why four?
Four isn't a magic number unless you're counting letters in cuss words, so you can feel free to play around with my list to suit your tastes. However, the point is to keep the list short and simple and avoid information overload. After all, the idea is for this to be a quick reference when it's time to buy, not an exhaustive rehashing of all of your diligent research.

Back to that watchlist
Having a watchlist where you can keep up with what's going on with the stocks on your radar is essential. The metrics above aren't written in stone and having the targeted coverage that the Fool's watchlist provides can keep you up to date on any changes. You can add companies from this article to your watchlist by clicking the "+" icons above, or you can start up a fresh watchlist and add whatever stocks you want.

As an added bonus, by setting up a watchlist you'll get access to a special report from our founding Fools, "6 Stocks to Watch from David and Tom Gardner."

Berkshire Hathaway, Coca-Cola, and Sysco are Motley Fool Inside Value picks. Berkshire Hathaway is a Motley Fool Stock Advisor recommendation. Coca-Cola and Sysco are Motley Fool Income Investor picks. The Fool owns shares of Berkshire Hathaway, Coca-Cola, and Raytheon. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway and Sysco, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (5) | Recommend This Article (29)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 18, 2011, at 3:45 PM, Borbality wrote:

    How similar is this Buffett Ratio to ROA? I'm trying to get a visual on how they would differ.

  • Report this Comment On March 18, 2011, at 3:59 PM, TMFKopp wrote:

    @Borbality

    Unfortunately, Buffett didn't spell out the specifics of the calculation, so I can only assume exactly how he's calculating it.

    However, since he's using "net tangible assets" we're basically talking about tangible book value or tangible shareholders' equity. So that's how it would differ from ROA.

    The way I think about it is like ROIC less the impact of intangible assets.

    Matt

  • Report this Comment On March 21, 2011, at 1:07 AM, Glycomix wrote:

    Please remove the advertisements.

    If you need to ban people from posting. Why don't you ban those who produce advertisements such as iuhoioipo rather than those who disagree with commentators.

  • Report this Comment On March 21, 2011, at 3:29 PM, TMFKopp wrote:

    @Glycomix

    We're working on getting the spam situation under control. It bugs the heck out of me too.

    Matt

  • Report this Comment On March 22, 2011, at 8:36 PM, DDHv wrote:

    I keep a price watchlist in addition to the primary one. This is on a spreadsheet. On the price list, stocks are ranked by a figure that is proportional to how close they are to the weekly low, and how close they are to the biannual low. Two prices are calculated for each stock. These are adjusted by low rank so that the buy prices range from near the current price (the lowest) to near the biannual low. The sell prices range from near the biannual high (the highest) to near the current price.

    Whenever there is a sufficient jump in a given stock, it can trigger a buy or sale. The probability is highest for the companies which are the best bargains. With a general jump, several may trigger. The spread of the price columns is reduced when there is an action, and increased a smaller amount weekly when nothing happens.

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