10-Minute Stock Test

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With over 50,000 stocks traded publicly, you need a way to quickly decide which ones deserve your time.

Pat Dorsey's "The Five Rules for Successful Stock Investing" (2004) offers a practical solution with his 10-minute stock test.

By asking specific questions about company quality, profitability, and financial health, you can quickly determine whether a stock deserves further investigation or should be eliminated from consideration.

These tests serve as starting points rather than definitive rules, with exceptions existing for every guideline.

You should begin by eliminating the obvious poor investments that clutter the market.

Companies with tiny market capitalizations and those trading on over-the-counter (OTC) markets should be avoided due to their speculative nature and limited information disclosure.

Foreign companies that don't file regular financials with the SEC present similar problems. Many large foreign firms publish full financials only annually and issue brief quarterly press releases, making it difficult to track their progress consistently.

Initial public offerings (IPOs) rarely make good investments since companies typically go public when they can command premium prices from enthusiastic investors. These young firms lack proven track records as well.

The exception is spinoffs from larger parent companies, which often represent solid businesses with long operating histories that the parent no longer wants to manage.

Money-losing companies often sound the most exciting, whether they're developing novel medical treatments or launching revolutionary products/services.

However, these single-product companies face all-or-nothing scenarios where failure is statistically more likely than success.

Unless you're seeking high-risk speculation, avoid any firm that hasn't proven it can generate operating profits. The ability to earn money validates a business model and demonstrates that customers value what the company offers.

Profits can appear on paper before cash arrives in the bank, but every company must eventually generate actual cash.

Fast-growing firms sometimes report profits while burning through cash, creating an unsustainable situation that leads to financial distress.

Companies with negative operating cash flow need additional financing through bonds or stock issuance. Bond financing increases the company's leverage and financial risk, while issuing new shares dilutes your ownership percentage. Neither outcome benefits existing shareholders.

For non-financial companies, use 10% return on equity (ROE) as your minimum threshold.

For reference, the ROE formula is shown below:

Pat Dorsey states that if a company can't generate double-digit returns on shareholder equity at least four out of every five years, it likely isn't worth your time.

Financial firms require higher capital bases to operate safely and generate lower returns on that larger equity cushion, so raise your ROE requirement to 12% for banks and insurers.

Always verify that high ROEs come from operational strengths rather than excessive borrowing. A company generating 20% ROE through minimal leverage demonstrates much higher quality than one achieving the same return by loading up on debt.

Cyclical companies are the exception since their results fluctuate significantly with economic conditions. The best cyclical firms still generate profits and decent ROEs even during industry downturns, proving their competitive strength.

Quality companies deliver reasonably steady growth year after year.

When earnings bounce wildly between gains and losses, the company either operates in a highly volatile industry or regularly loses to competitors.

Volatile industries aren't necessarily bad investments if the long-term outlook remains positive and shares trade cheaply.

However, companies that can't maintain consistent performance against competitors signal potential fundamental problems that may worsen over time.

Companies carrying substantial debt require extra scrutiny.

For non-bank firms, two key ratios help identify dangerous debt levels. A financial leverage ratio above 4 or a debt-to-equity ratio exceeding 1.0 signals that a company may be taking on too much financial risk.

The financial leverage ratio shows how much a company relies on borrowing to acquire assets:

A ratio of 4 means the company has $4 in assets for every $1 in equity, with the remaining $3 funded by debt. This heavy reliance on borrowed money amplifies both gains and losses.

The debt-to-equity ratio directly compares what a company owes to what shareholders have invested:

When this ratio exceeds 1.0, the company owes more to lenders than shareholders have put into the business.

This imbalance makes the company vulnerable to economic downturns or unexpected challenges, as debt payments must be made regardless of business conditions.

When evaluating these highly leveraged companies, ask three key questions:

Free cash flow (FCF) represents cash truly available to shareholders after maintaining and investing in the business:

You should prefer firms that create FCF to ones that don't, and firms that create more FCF to ones that create less.

Pat Dorsey suggests using a 5% FCF-to-sales ratio as a minimum benchmark for quality.

Negative FCF doesn't automatically disqualify a company. Firms investing heavily in high-return projects may generate negative FCF while creating substantial value.

Starbucks and Home Depot both burned cash for years while building their store networks, yet clearly created large amounts of economic value during that period (around 2001).

Therefore, companies with negative FCF but solid ROEs deserve consideration if you believe management invests capital wisely. The key is having the confidence that cash invested today in expansion projects will generate attractive future returns.

If a firm already looks questionable and has a history of large one-time charges, skip it.

Frequent “one-time” charges suggest both complicated financials and management teams potentially hiding or distorting poor operating results.

Consistent share count increases above 2% annually indicate either heavy acquisition activity or generous employee stock options.

Most acquisitions destroy value, making acquisition-heavy companies risky investments.

Excessive option grants slowly dilute your ownership as employees exercise their awards.

Conversely, shrinking share counts signal shareholder-friendly management. Share buybacks return excess cash to shareholders responsibly, though only when executed at reasonable valuations.

You should avoid companies repurchasing overvalued stock, as they waste shareholder capital by overpaying for their own shares, just like any investor overpaying for shares.

If a company passes these tests and seems worthy of further analysis, Pat Dorsey provides an overview of the stock research process you should follow afterwards:

When your analysis shows the stock trading well below intrinsic value and the multiples look reasonable, you may have found an investment opportunity worth pursuing.