Evaluating stocks is an exercise in critical thinking. It requires fair bit of work and thinking, but it’s worth the effort for the clarity we get.

When we buy a stock, we are buying piece of a business. By asking a series of structured questions, we try to understand how the underlying business works, predict what it will be like in a few years, and estimate a reasonable price for buying it whole.

We don’t want to spent weeks and months doing complex analysis and financial modeling like institutional investors. We want to do simple, but accurate evaluation of publicly traded companies by putting in reasonable effort to arrive at a conclusion that makes sense for us, the individual investors.

Even though we only intend to buy few stocks, we should think that we will buy the whole business and keep it for many years. And to figure out if we want to purchase it, we need to answer these six questions:

1. What does the business do?
2. Is it a good business?
3. If it’s a good business, why is it good?
4. Can it remain a good business in future too?
5. Is it run by competent and honest people?
6. Is it available at a fair price?

Let’s take a hypothetical example to illustrate how this investing framework can be applied. Imagine that a popular sandwich store in our neighborhood just became available for sale. We have money in bank and are seriously considering buying it. We will go step by step to answer these questions (We will skip management analysis in this example as it’s more applicable for public companies)

1. What does this business do?

We want to figure out how does this business work and make money. There are four main things to understand:

• What does the business sell? (sandwiches, drinks, cookies)
• Who are the customers? (locals vs tourists, old vs young, rich vs poor)
• How does it sell its products and services? (what are the channels: in-store vs online orders vs group catering)
• What are its costs? (ingredients, labor, rent, marketing)

2. Is it a good business?

Once we have a decent understanding of how the business works, we want to look at its health. More specifically,

• Does it have a clean balance sheet? (is it loaded up with debt? And how much assets the store owns?)
• What are the sales of the store? (revenue from sale of food and drinks)
• What are the profit margins like? (gross profit and net profit)
• How much cash does the store generates? (operating cash and free cash flow)
• What’s the return on invested capital? (Am I better off just buying risk-free bonds?)
• How have these numbers grown or declined in last few years? How does these numbers compare to industry average and other similar food joints?

3. What makes it a good business?

So far if you think it’s a good business, you now want to understand why is it so and how it stands out from competition.

• Who are its competitors? (local joints, larger chains, other eateries)
• Does it have a competitive advantage or a “moat” (hard to have moats in food industry for local stores, but few have a strong brand)
• Why do customers keep coming back to this place? Or will they keep paying even when we raise prices?

4. Will it continue to be a good business in future?

This is where we need to think strategically about future, especially about three aspects:

• Is the company’s moat durable? (If the owner or chef leaves, will the business tank? What can harm the brand?)
• What are the main risks the business face? (What if key suppliers go out of business or increase prices? Can changing customer preferences towards healthier foods impact sales?)
• What are the biggest opportunities? (is there potential for expanding store locations, increasing menu items, hiking prices, or cutting costs)

5. Is the business available at a fair price?

Now we bring it all together and assess if the current offer price is reasonable or too high. This needs a bit of number crunching, but we will avoid complex projections on heavy excel sheets.

• What drives earning growth? (economy in general, influx of residents, inflation?)
• How would the earnings grow in next few years? (Future is uncertain and probabilistic so we need to think of worst, likely, and best case scenarios)
• What would be the value of this business after a few years? (what kind of multiple it is available today on earnings or sales? what will be a reasonable multiple in future?)
• Will I loose a lot of money if things go wrong? (Is there some margin of safety in price I am paying)
• Given all this, what’s a price that I am happy to pay today? (One that will meet my return expectations at risk I am comfortable with)
• If the asking price is higher or lower than my happy price, why is that the case? (Do I understand why owner is asking for lower price or why market is valuing it lower? What am I missing?)

After we have good enough answers to these questions, we will put pen to paper and summarize our thinking in a crisp 1-pager. This will become our investing thesis and will guide us to make a buy or pass decision. This is exactly the same process we will follow for analyzing any publicly listed company.

For every dozen or so 1-pagers you write, you will maybe invest in one. Sometimes we won’t understand the business well enough and other times we won’t like the price. That’ totally okay! We have done the hard part already. We will keep the stock in our watchlist, move on to the next stock, and update our analysis from time to time.

As you can imagine, this is simple but not easy. It’s not for everyone. But it is very satisfying and intellectually stimulating. And like every other skill, it gets easier with practice. The learning compounds quite rapidly as we build a repository of businesses in our mind and slowly expand our circle of competence.

In a future post, I will dive deeper into each part of the framework in more detail with example of a real stock.

Happy investing!