David Gardner's Step-By-Step System to Measure Risk in the Stock Market

David Gardner's step-by-step system to measure risk

How do you measure risk in the stock market?

The word risk is thrown around in the financial media and often quantified with meaningless terms like "medium" or "high." Several years ago, Motley Fool Co-founder & Chief Rule Breaker David Gardner designed a simple step-by-step strategy to help investors measure a stock's risk level.

Two years ago, he covered the entire system in an episode of the RBI podcast. I've included David's definition of risk, his scoring system, and all 25 questions below.

David defines risk 👇

"Riskiness comes down to the chance that you would lose a substantial portion of your capital if you held a stock over a meaningful portion of time (3 years)."

How does the system work?

There are 25 questions with Yes or No answers.

Yes = 0

No = 1

Go through all 25 questions & add up the number of questions that received a No. This is your risk rating. The higher the score, the riskier the stock.

The questions are divided into categories

• Company

• Financials

• Competition

• Stock

• Management Team

• Rule Breaker Attributes

• Final Five

The Company

1. Was the company profitable over the last quarter & the last 12 months?

2. Was the company cash flow positive over the last quarter & the last 12 months?

3. Does the company rely on recognizable branding that is truly valued by its user base?

4. Has the company diversified its buyer base so that no single customer accounts for more than 20% of its revenue?

5. Does the company receive positive word of mouth from its customers?

The Financials

6. Did the company grow its sales by 10-40% annualized over the past 3 years?

7. Can the company operate its business in the next 3 years without external funding?

8. Does the company maintain a high standard of disclosure consistent with SEC guidelines in the U.S.?

9. Would an intermediate-level investor find the financial statements & management ownership disclosures easy to understand?

10. Did the company report R.O.E. (Return on equity) of 15% or higher over the last year?

The Competition

11. Is the company free of any direct competitors that possess substantially greater financial resources?

12. Is the company free of any disruptive upstarts that are visibly challenging its business model?

13. Would potential new competitors face high economic, technological, or regulatory barriers to compete with this company?

The Stock

14. Does the company have a market cap of $10 billion or more?

15. Does the stock have a beta of 1.3 or less?

16. Does the stock have a positive price-to-earnings multiple (PE ratio) less than 30?

The Management Team

17. Do any of the founders own at least 5% of the company?

18. Do the top 3 officers have more than 15 years of combined leadership at the company?

Rule Breaker Attributes

19. Does this company meet the majority of the Rule Breaker attributes?

20. Is the company easily able to withstand binary outcomes?

Final Five

21. Is this company fault-free & fraud-free in all its corporate statements & deeds?

22. Do you want to know more about this company? Are you willing to dig deeper?

23. & 24. Create 2 insightful questions specific to the company you are rating?

25. Can you be certain that the company is invulnerable to external world or macroeconomic events such that you’re sure you can get all of your capital back?

*Answers to #21 & #25 are always no - This is because there are zero risk-free companies.

Notes:

◾Some of these questions are subjective. This means you and I can have different scores for the same company.

◾No one system is perfect. Tweak it to suit your investing goals.

◾Running your holdings through the system is a great way to learn more about the companies you own.

Thanks for reading, and Happy Investing!