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I'm currently researching several new companies that could eventually find their way into my Stocks and Shares ISA.
But I'm not looking for the stock that's gone up the most this year.
I'm not trying to predict what will happen next month either.
I'm looking for good businesses.
Companies generating cash, growing earnings, managing their debt and ideally returning increasing amounts of money to shareholders over time.
This is also one of the biggest ways my approach to individual stocks has changed.
I've sold companies in the past because they no longer fit what I'm looking for. A high dividend yield alone isn't enough for me anymore.
I want quality and, ideally, growth.
So here's the framework I'm currently using when researching potential additions to my portfolio.
Start With the Business, Not the Share Price
It's very easy to open a stock and immediately look at its chart.
It's down 30%. Is it cheap?
It's up 50%. Have I missed it?
Neither tells us whether we're looking at a good business.
A falling share price can make a great business more attractive, but it can also be the result of a deteriorating company.
Likewise, a stock hitting all-time highs isn't automatically expensive.
That's why my research process now looks more like this:
Business → Financials → Dividend → Valuation → Share Price
The business comes first.
1. Is Revenue Growing?
One of the first things I'll look at is revenue.
Is the company selling more products or services than it was five years ago? I'm not necessarily looking for explosive growth.
For the types of established businesses I invest in, I'd often prefer steady and predictable growth.
I'll normally look at several years rather than a single reporting period.
One bad year doesn't necessarily worry me.
A five-year trend moving in the wrong direction might.
2. Are Earnings Per Share Growing?
Revenue only tells us part of the story.
Next, I want to know whether the business is actually becoming more profitable.
One particularly useful metric here is Earnings Per Share or EPS.
Think about the company as a pie.
As a shareholder, I own a tiny slice of it.
I don't just want the pie getting bigger. I want the earnings attributable to my individual slice to increase too.
That's why consistent EPS growth can be such an important part of my research.
3. Follow the Cash
This is where things start getting particularly interesting.
A company can report an accounting profit, but dividends aren't paid with accounting profits.
They're paid with cash.
That's why I'll look closely at operating cash flow and free cash flow.
In simple terms:
Free Cash Flow = Operating Cash Flow − Capital Expenditure
That free cash flow can then be used to reduce debt, reinvest into the business, make acquisitions, buy back shares or pay dividends.
A question I increasingly ask when researching companies is:
Where is the cash actually going?
