Nearly all the best stock picks share similar characteristics, and this article explains the framework to identify these ideas. Understanding this is important because picking a great stock is one of the most valuable skills you can develop. You can reach your financial and career goals faster by learning this investment skill.
Anyone can learn to pick a stock using these three steps. That’s not to say learning this framework came easy for me. This comes straight from my experience on Wall Street. I worked in the investment business for ten years, with seven years as an equity research analyst at BMO.
When I was at BMO, we provided investment ideas to the world’s largest hedge fund and asset managers, such as JP Morgan, Point72, Citadel, and Bank of Montreal. One of my stock picks turned into one of the highest-returning stocks (MSCI, +711%) in the S&P 500 between 2016 and 2021.
The stock pick is even featured on the front cover of Barrons1.
Do you want to know a secret?
We used this exact framework to identify the best ideas every time. Let’s dive in.
#1: Fundamentals – Look for Earnings Potential
“Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten, and twenty years from now.”
—Warren Buffett (The Essays of Warren Buffet)
Here’s how it works:
- The value of a stock is often based on the business’s earnings potential. More earnings per share = more value for shareholders.
- This is why when we research a stock, we forecast the company’s earnings per share for the next few years (ideally five to ten years).
- The essential assumptions of a business’s earnings are its sales, profit margins, and capital use (which determines per-share metrics).
We estimate the long-term returns of the stock based on the company’s expected long-term earnings.
Fundamentals in Practice
Paylocity’s (PCTY) provides payroll-related software to small businesses. The company’s sales are driven by new customers and the number of employees on the payroll. Here are its long-term financial targets2:
I’ll estimate the growth the business can achieve in new customers and payroll employees. Once I know the business drivers, I can use a financial model to get to the targets. That gets me to about 17-19% growth in earnings per share over the next five years. That indicates the potential long-term returns for shareholders (assuming valuations stay the same).
My financial model:
#2: Expectations – Look for Upside in Estimates
“You make investing decisions based on what everyone else will think in the future.”
—Henry Chien (Better Investment Decisions)
Here’s how it works:
- Stocks are freely traded among investors, which is why the stock’s price reflects investors’ current expectations of the business’s outlook.
- We’ll approximate the change in expectations to forecast the future price. Usually, we’ll use the mean of research analyst earnings estimates.
- Take your earnings estimate. Compare it with the consensus estimates to approximate the change in estimates.
💡 Quick note: Don’t use current analyst estimates to calculate the stock’s future price. That’s a common mistake. The stock’s price already reflects those expectations. Expectations are a core principle of stock analysis:
Expectations in Practice
When I look at analysts’ estimates for Paylocity’s earnings (at the time of writing), it looks like there are expectations for a slowing in earnings growth by FY2024. That is likely due to investor fears of a recession.
However, this forecast might be too pessimistic. Recent trends in the labor market have been positive. Paylocity has shown an ability to grow in prior downturns. In my view, those estimates for FY2024 are likely to be too low and could be revised upwards.
Analyst’s estimates on July 31st, 2024 (from Koyfin):
#3: Valuation – Find a Valuation Opportunity
Here’s how this works:
- The market price of a stock is like a debate between investors on the appropriate valuation of the business.
- Since investors judge the business’s earnings potential, the forward price-earnings ratio reflects investor expectations.
- We’re looking for scenarios where this forward valuation multiple could improve, or at least remain stable, over the next few years.
- Sometimes we look for a catalyst or a change that will cause the stock to re-value. It could be as simple as a stronger earnings outlook (faster growth), which leads to a higher multiple.
Simple, right? To assess value, we look at multiples of next year’s earnings (at least) and earnings over the next few years. Looking ahead for earnings is especially important for growth investors:
Valuation in Practice
Paylocity’s forward valuation multiples aren’t cheap on an absolute basis (43X forward P/E)—at first. However, this multiple seems reasonable when I dig into the business’s growth prospects and analyze the valuations of similar companies over time.
The historical PEG ratio (price to earnings to growth ratio) of mature payroll companies like Paychex and ADP is about 2.7. If Paylocity achieves its growth targets and market-leading position, it could achieve 17-19% in annual earnings-per-share growth. That PEG ratio implies Paylocity’s stock price-earnings multiple could be 46x.
My valuation estimates:
The Framework to Identify an Ideal Stock
- Look for earnings potential. (Forecast the business’s earnings).
- Look for an upside in expectations. (Look for positive change in estimates).
- Find a valuation opportunity (Identify a higher valuation scenario).
The Framework in Practice
Paylocity is a leader in the payroll and human capital management software niche for small businesses. There’s a good chance it can achieve 17-19% earnings growth over the next five years. Estimates for FY2024 also appear low (at ~11% earnings growth) when Paylocity achieved ~15% earnings growth in prior down markets. If estimates come up—the multiple could also re-value to the 46x historical range—a $350 stock by 2024.
The framework is used by the best hedge fund investors:
Finding the Great Stock Picks in Short
The framework of identifying the best stock picks means having a good perspective of the business’s outlook, investor psychology, and investment valuations.
One way to approach stock investing is by following the three-part process of 1) evaluating the business’s earnings, 2) approximating the change in estimates, and 3) identifying valuation scenarios.
Finding great stock ideas isn’t about being the first to find the stock. More often, making a great stock pick is about connecting perspectives.
