A Step-by-Step by Guide for Applying David Gardner's 25-Question Risk Framework to Every Company on Your Watchlist
Hey Friends,
I discovered David Gardner's 25-Question Risk Framework a couple of years ago, and as you've probably realized by now, I'm a big fan. What David and his team built gives investors a tangible score to measure a stock's risk level.
Like every framework, it takes a few times going through to understand the scores and the best way to use it. Not only is it good for measuring risk, but the questions cover numerous areas and are a great way to learn about a business you are interested in.
The first time I went through the framework, I had a hard time answering the questions. I wasn't sure where to find the information and what sites I could trust. The more I did it, the easier it became.
Over the last few months, I documented my process for answering each question and will share it with you today. For a new investor, using this framework can supercharge your journey. Once you go through the material a few times, you will begin to shape and build your own process (At least, this is what happened to me).
For those who are more experienced, it's a great way to get to know a business quickly to see if it is worth your time.
Here's how the guide works:
If you are an experienced investor, this spreadsheet is all you will need. Save a copy, pick a business you want to learn more about and dive into the framework.
If you are like me and need some help, I've provided notes (below) on each question. Before you start, listen to this podcast where David takes two businesses through the framework. If you want to look at all 25 questions, you can go here.
The first time will be a challenge. You will learn to navigate a 10-K and make basic financial calculations. Like anything, the more you practice, the easier it gets.
Now, if you're ready, I've divided the material into four days. I like to go through it all at once, but you can do it as fast or slow as you want.
As you go through the questions, one by one, keep score in the spreadsheet (link to spreadsheet) and record your notes. If you have questions, use the guide to direct you. I've provided links and videos that I used to find the answers. The resources are there if you need them.
After you run a few businesses through, the spreadsheet will become a great resource to compare companies in the same industry.
Please note: I am still learning, so if you notice a mistake or know a better way to come up with the information, please let me know.
If you would ever like to run through this framework in a community of investors, drop me an email. If there is enough interest, I will set up a challenge where we can go through the material together and learn from each other.
If you have any questions, feel free to reach out. Happy Investing!
DAY 1- Questions 1-5 - The Company 👇
1. Was the company profitable over the last quarter & the last 12 months?
What: Net income is calculated as revenues minus expenses, interest, and taxes. It is a useful number for investors to assess how much revenue exceeds the expenses of an organization. This number appears on a company's income statement and is also an indicator of a company's profitability.
Why: "I think a company that isn't making money is riskier than a company that is making money." - David Gardner
You probably didn't need David Gardner to tell you that, but it's important to understand the risk involved when investing in an unprofitable business.
Where: Locate the income statement and find the figures for net income. The answer is yes if the last quarter and TTM (Trailing Twelve Months) data are positive.
*I recommend using the company's investor relations page for most financial data. You can find the 10K or 10Q for the most recent data.
Websites like Yahoo Finance and TIKR are also solid options and are easily accessible.
2. Was the company free cash flow positive over the last quarter & the last 12 months?
What: Free cash flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.
Free Cash Flow = Operating Cash Flow - Capital Expenditures (Cap Ex)
Why: Free cash flow is crucial because it's a reliable measurement of how efficiently a company produces cash from its regular business activities.
Where: Locate the statement of cash flows and find the figure for operating cash flow. Take that figure and subtract capital expenditures. The answer is yes if the last quarter and TTM (Trailing Twelve Months) data are positive. Like several financial metrics, FCF can be manipulated. I've provided some references to help you understand the various nuances.
*I recommend using the company's investor relations page for most financial data. You can find the 10K or 10Q for the most recent data.
Websites like Yahoo Finance or TIKR provide solid options and are easily accessible.
References:
I've compiled a list with a few of my favorite resources for understanding free cash flow.
If you want help reading a cash flow statement, this 👇 is a straightforward explanation from Brian Stoffel and Brian Feroldi from The Motley Fool.
3. Does the company rely on recognizable branding that is truly valued by its user base?
What: Brand refers to a business and marketing concept that helps people identify a particular company, product, or individual. Brands are intangible, which means you can't actually touch or see them. As such, they help shape people's perceptions of companies, their products, or individuals.
Why: The power of branding is evident in many ways. A strong brand can help a company succeed in a price battle, as customers are often willing to pay more for a product or service from a brand they trust. A brand can also help a company thrive during a recession, as customers may be more likely to stick with a familiar brand rather than try a new one.
Where: This is an obvious yes or no answer for most companies, but you might need to do some digging for industries that aren't as well known. Try googling, "Does _______ have a strong brand?" Sites like Reddit and Glassdoor can also be helpful and don't forget about the 10K.
Articles/websites on Branding:
◾Global Brands Matter (The graphic on this page is from globalbrandsmatter.com)
◾What is the Power of Branding?
4. Has the company diversified its buyer base so that no single customer accounts for more than 20% of its revenue?
What: Customer or client concentration refers to how a business's revenue is spread across its client base. Suppose a significant percentage of a company's overall revenue relies on a single or small group of customers. In that case, that business may have a high level of customer concentration.
Why: Companies that rely on a single customer for more than 20% become tied to that customer's success. A diversified customer base protects future revenue streams and makes the business less risky.
Where: Locate the company's 10K (Annual Report). This can be found on the company's investor relations page or SEC.gov.
Directions for finding the 10K at SEC.GOV
Under the search bar at the top, click on company filings.
Under person and company lookup, type the company ticker
When your company pops up, click on its name in the dropdown box
Click on view filings and scroll down until you see the 10K
Once you find the document, type "concentration" in the search bar. This should take you to the portion of the report on customer concentration. They should disclose any customers that represent more than 10% of revenue. Note: Not all companies list it as "customer concentration," so you may have to get creative. The word "customer" will produce more hits and take a while to sift through, but should get you there eventually.
The information on customer concentration can be included in multiple sections of the 10-K. It's typically included in the "Risk factors" section but can sometimes be found in several other sections. If you need help, let me know.
5. Does the company receive positive word-of-mouth from its customers?
What: Word-of-mouth marketing (or WOM marketing) is when a consumer's interest in a company's product or service is reflected in their daily dialogues. Essentially, it is free advertising triggered by customer experiences—and usually, something that goes beyond what they expected.
Why: Companies that receive positive word of mouth have loyal customers and lower customer acquisition costs. This results in repeat purchases, new customer wins, higher margins, and, for our purposes, less risk.
Where: This goes hand and hand with branding, so if you're dealing with the non-obvious, I would go back to Google, Reddit, customer reviews, etc. Find out what customers are saying about the product.
DAY 2- Questions 6-10 - The Financials 👇
6. Did the company grow its sales by 10-40% annualized over the past 3 years?
What: Revenue is the money generated from normal business operations. It is the top-line (or gross income) figure from which costs are subtracted to determine net income. Revenue is also known as sales on the income statement.
Why: It's important to think about what kind of growth you are looking for. Our question is targeting a range between 10-40%. Why? A healthy double-digit growth rate indicates growing customer demand and innovation. Rates higher than 40% are unsustainable and risky. These stocks are typically hit hard when their growth rates begin to decline.
Where:
Locate the income statement and find the figures for revenue. You will need the last 4 years of total revenue.
Using this CAGR calculator take the figure for 2019 and put it in the starting value box.
Take the figure for 2022 and put it in the ending value column. For "number of periods," put 3. Click the calculate button, and you have your 3-year CAGR.
*I recommend using the company's investor relations page. From there, you can click on the 10K or 10Q to get the most recent data.
Websites like Yahoo Finance and TIKR are also solid options and easily accessible.
7. Can the company operate its business in the next 3 years without external funding?
What: External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing, which consists mainly of profits retained by the firm for investment. There are many kinds of external financing.
Why: Ideally, we are looking for companies that can finance their growth with their profits. The more a company relies on debt, the more risk it carries.
Where: Ask these questions: Are they profitable? Is the business capital intensive? Do they already carry a significant portion of debt?
*If the company already has debt, but you believe they can run the business and afford their current debt payments without additional financing, the answer is yes.
*I recommend using the company's investor relations page. From there, you can click on the 10K or 10Q to get the most recent data.
Websites like Yahoo Finance and TIKR are also solid options and easily accessible.
8. Does the company maintain a high standard of disclosure consistent with SEC guidelines in the U.S.?
What: "The Securities and Exchange Commission (SEC) is a U.S. government oversight agency responsible for regulating the securities markets and protecting investors."
Why: Markets are full of scandal and deceit. If you invest long enough, odds are an accounting scandal will impact you.
Where: Google the company name and the words "SEC violations." For example: "Coke SEC violations." If you see multiple violations, it should be a red flag. Next, visit the investor relations page for the company. Do they communicate clearly and consistently with shareholders?
9. Are the financial statements & management ownership disclosures easy to understand?
What: Financial statements should be easy to locate and straightforward. While there is a learning curve to understanding and interpreting the statements, those with a basic knowledge of accounting should be able to get a clear picture of a company's financial health by looking over the financials.
Why: Similar to the question before on SEC guidelines, a lack of transparency often indicates the company is hiding something. You want to invest in businesses that are easy to understand.
Where: Visit the Investor Relations page and explore the financials.
10. Did the company report R.O.E. (Return on equity) of 15% or higher over the last year?
What: Return on equity (R.O.E.) is a measure of financial performance calculated by dividing net income by shareholders' equity.
Why: This ratio tells you how well the company uses investments to grow earnings. A high R.O.E. is an indication of a well-managed company.
Where: I use the free version of TIKR Terminal. Click on ratios, and you will find five years of data. If you have more time, you can always do the calculations on your own.
DAY 3- Questions 11-18 - Competition, Stock, & Management👇
11. Is the company free of any direct competitors that possess substantially greater financial resources?
What: One of the most significant challenges a business can face is intense competition. If multiple companies sell the same product, it can become a game of who has the most money.
Why: Competition drives margins down and favors businesses with significant financial resources. Competing against companies with deep pockets is risky.
Where: For most companies, you will know who the competitors are, but if it's an industry you are unfamiliar with, try to explore using Google. Type "XYZ's biggest competitors" and see what you can find. Once you've discovered the competitors, you can look at the balance sheets to see what they are up against.
12. Is the company free of any disruptive upstarts that are visibly challenging its business model?
What: Is this a lumbering giant that could be disrupted by an upstart? Look at the industry your business is in and take notice of the new players and innovations being made in the industry.
Why: The more competitive the industry, the more companies there will be trying to innovate and come for the top players.
Where: Again, Google is your best friend.
Try these: Google "innovation in XYZ field," or "recent IPOS in XYZ field."
13. Would potential new competitors face high economic, technological, or regulatory barriers to compete with this company?
What: The term "economic moat," popularized by Warren Buffett, refers to a business's ability to maintain competitive advantages over its competitors in order to protect its long-term profits and market share.
Why: A company is only as strong as its competitive advantage. They will be less risky if they can make it difficult for other companies to compete with them.
Where: This is one of the most important things to understand about a business. There are several places you can go to help you understand the moat.
Here are a few:
Company website
Investor presentations
Earnings Calls
Glassdoor ratings
Customer reviews
Ask: Do they have a patent, proprietary knowledge, 1st mover advantage, network effects, outstanding company culture, etc.?
14. Does the company have a market cap of $10 billion or more?
What: Market capitalization, or "market cap," is the aggregate market value of a company represented in a dollar amount. Since it represents the "market" value of a company, it is computed based on the current market price (CMP) of its shares and the total number of outstanding shares.
Why: A market cap of $10 billion or more often represents a more established company. This means more customers, more employees, etc. Companies that fall under this threshold often hold a higher level of risk.
Where: Go to Yahoo Finance, type in the ticker symbol, and look for the figure next to market cap.
15. Does the stock have a beta of 1.3 or less?
What: Beta (β) is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole (usually the S&P 500). Stocks with betas higher than 1.0 can be interpreted as more volatile than the S&P 500.
Why: Stocks with a high beta can move quickly in either direction. This makes them riskier than stocks with a beta closer to 1.
Where: Go to Yahoo Finance, type in the ticker symbol, and look for the figure next to beta.
16. Does the stock have a positive price-to-earnings multiple (PE ratio) of less than 30?
What: The price-to-earnings ratio is the ratio for valuing a company that measures its current share price relative to its earnings per share (EPS). The higher the ratio, the riskier the business.
Why: Companies with high valuations are more susceptible to large drops when they encounter challenges.
Where: Go to Yahoo Finance, type in the ticker symbol, and look for the figure next to PE Ratio.
17. Do any of the founders own at least 5% of the company?
What: This is often referred to as skin in the game. You want to know what percentage of the company the founder owns. David looks for 5% or higher.
Why: High insider ownership typically signals confidence in a company's prospects. It aligns management with stakeholders and incentivizes them to think long-term and maximize shareholder value.
Where: Go to SEC.gov and locate the most recent 14A for the company you are researching. This is difficult to find unless you know where to go. I've attached a YouTube video below where he walks you through the process. You can start the video at the 3:20 mark.
18. Do the top 3 officers have more than 15 years of combined leadership at the company?
What: You are looking for an experienced management team.
Why: A tenured team offers experience, patience, and loyalty. They have seen the business through ups and downs. All things being equal, the more experience, the less risk.
Where: Locate the leadership page on the company website. They typically contain bios that detail how long each officer has been with the company. Add up the totals for the top 3 officers. (CEO, COO, CFO)
DAY 4- Questions 19-25 - Rule Breaker Traits & The Final Five👇
19. Does this company meet the majority of the Rule Breaker attributes?
What: David created the Rule Breaker framework in the 90s and has used it to uncover mega winners like Amazon, Tesla, Netflix, etc. I've listed all six attributes below. Take a look and determine if your company has at least 4.
Trait #1 Top-Dog and First Mover in an Important and Emerging Industry
Trait #2 Sustainable Competitive Advantage
Trait #3: Strong Past Price Appreciation (Referring to the stock)
Trait #4 Good Management & Smart Backing
Trait #5 Strong Consumer Appeal
Trait #6 The Stock is Considered "Overvalued" by the Financial Media
References:
Motley Fool podcast - 6 Traits of a Rule Breaker Stock
Article - 6 Traits of a Rule Breaker Stock
Why: David has incorporated his Rule Breaker framework inside this risk framework. For his purposes, stocks with most of these traits hold less risk. While this may or may not fit in your framework, it's a helpful exercise to learn more about your business.
Where: After digging through the 10-K, investor relations website, investor presentations, etc., over the last few days, you can probably answer these questions easily.
20. Is the company easily able to withstand binary outcomes?
What: A binary outcome is a general term that implies only two possible outcomes to a certain situation.
Examples:
Dependence on one supplier
Dependence on one customer
A pharma company waiting for FDA approval.
Why: Binary outcomes typically result in all-or-nothing scenarios. A stock with a binary outcome carries significantly more risk than a company with optionality.
Where: These are easy to spot once you have researched the business.
References:
21. Is this company fault-free & fraud-free in all its corporate statements & deeds?
Questions 21 and 25 are designed to receive a no. David built the framework this way because there are zero risk-free businesses.
In this case, we can't know with certainty whether the company is 100% truthful. There might be red flags, but we typically discover these things after the fact.
Your answer for 21 is "No."
22. Do you want to know more about this company? Are you willing to dig deeper?
What: This pertains to your interest in the company. Do you like digging into the business, or do you consider it a chore to learn about?
Why: If you aren't interested in the company, you are less likely to stay up to date on what is happening and risk missing out on important information.
Where: If you selected a new business for this challenge, you probably know whether they pique your interest by now. If they don't, it might be time to move on.
23 & 24 - Create two insightful questions specific to the company you are rating.
What: Ask the most insightful questions you can come up with.
Why: These allow you to ask company-specific questions.
Where: Are there specific metrics you are watching? Is there a direction you feel the company should be heading? Use the knowledge you have gained over the last five days to create two unique questions.
Note: It's important to note your bias when you create these questions. Whether you find yourself guiding to a yes or no, it's worth considering why you did so.
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?
Questions 21 and 25 are designed to receive a no. David built the framework this way because there are zero risk-free businesses.
In this case, there are always unknowns that we can't predict. This means we are always at risk of losing our capital.
Your answer for 25 is "No."