The Five Criteria: A Proven Strategy for Picking Great Stocks

The Five Criteria is a stock-picking framework that asks five questions of every company, in the same order, before any money goes in: Is it a great business? Does it have a durable moat? Is management working for shareholders?

Is the balance sheet sound? Is the price reasonable? A stock must pass all five.

It distils what Benjamin Graham, Philip Fisher, Warren Buffett, Charlie Munger and Peter Lynch spent careers learning into one repeatable process a beginner can use today. Where this fits: this is the home page of the Gingernomics method. Every other article on the site explains one part of it.

Why You Need a Framework at All

Most people buy stocks for the reason they happen to hear about them: a headline, a friend, a chart that went up. That produces a portfolio of stories, not a portfolio of businesses. When prices fall, there is nothing to anchor to, so they sell at the worst moment.

Benjamin Graham saw this more than seventy years ago. In The Intelligent Investor he wrote that “the investor’s chief problem — and even his worst enemy — is likely to be himself.” The market is not the enemy.

Our own impatience, overconfidence and fear are. A written framework is the fix. It does three jobs: It filters.

Out of thousands of listed companies, fewer than one in twenty will pass all five criteria. You stop wasting time on the other ninety-five. It protects.

Almost every permanent loss of capital — the overleveraged retailer, the serial acquirer, the hyped growth stock bought at 80 times sales — fails at least one criterion in plain sight. It teaches. Because you apply the same test every time, you can look back and see exactly which question you got wrong.

That is how investors improve. Charlie Munger liked to say “invert, always invert.” The Five Criteria is built on that idea.

Rather than asking “how could this stock go up?” , it first asks “what could make me lose money here?” — and removes those companies before you get attached.

The Five Criteria at a Glance

Criterion	The question	Gingernomics default threshold
1. Great business	Does it earn high returns on the capital it uses?	ROIC of 15%+ for five or more years; free cash flow at least 90% of net income
2. Durable moat	What stops competitors taking those returns away?	One identifiable moat source, and ROIC that held up through a downturn
3. Aligned management	Do the people in charge allocate capital like owners?	Share count flat or falling over five years; meaningful insider ownership
4. Sound balance sheet	Can it survive a bad year without diluting or defaulting?	Net debt below 2x EBITDA; interest coverage above 5x
5. Reasonable price	Does the price leave room for being wrong?	Free cash flow yield of 5%+, or 25%+ below a conservative intrinsic value

The order matters.

Quality comes first and price comes last. If you look at price first, a cheap-looking stock will talk you into forgiving a weak business. Graham called these “cigar butts” — one last puff, then nothing.

Buffett moved away from them, and summed up the shift in his 1989 letter: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” These thresholds are defaults, not laws. Banks, insurers and REITs need adjusted measures (we cover those in the sector guides).

But for an ordinary operating business, if you find yourself bending a threshold, write down why. Most of the time the honest answer is “because I already want to own it.”

Criterion 1: Is It a Great Business?

A great business turns a small amount of capital into a large, reliable stream of cash. The single best measure of that is return on invested capital (ROIC) — the profit a company earns on every dollar of debt and equity tied up in the business. Why 15%?

Most companies’ cost of capital sits somewhere around 8–10%. A business consistently earning 15% or more is creating real value on every dollar it reinvests. One earning 6% is quietly destroying it, even if profits are growing.

Look for: ROIC above 15% for at least five years. One good year proves nothing. Ten good years through a recession proves a lot.

Stable or rising gross margins. A company that can hold its margins while costs rise has pricing power. Cash conversion.

Free cash flow should be at least 90% of reported net income. If profits keep appearing on the income statement but not in the bank, find out why. Low capital needs.

The best businesses grow without constantly asking shareholders or lenders for more money. Philip Fisher, whose Common Stocks and Uncommon Profits shaped Buffett’s thinking, spent most of his research effort here — understanding the business itself before the numbers. Can you explain in two sentences how this company makes money, and why customers keep paying?

If not, it is outside your circle of competence for now. That is not a failure. It is a filter.

Go deeper: Return on Invested Capital: The Gold Standard of Business Quality · Different Business Models Explained · Red Flags in a Business

Criterion 2: Does It Have a Durable Moat?

High returns attract competition. Capitalism is designed to compete them away.

A moat is whatever stops that from happening. Pat Dorsey, formerly of Morningstar, grouped moats into five sources: Intangible assets — brands, patents, licences and regulatory approvals that let a company charge more or keep others out. Switching costs — it is painful, risky or expensive for customers to leave (think of the software that runs a company’s payroll).

Network effects — the product gets more valuable as more people use it, like a payment network or marketplace. Cost advantages — structural reasons the company can produce more cheaply than anyone else, such as scale or a unique asset. Efficient scale — a market only big enough for one or two players, so new entrants cannot earn a return.

The test is evidence, not a story. Every company claims a moat in its investor presentation. Real moats show up in the numbers: ROIC that stayed high through a recession, margins that did not collapse when a competitor cut prices, customers who stayed.

Go deeper: How to Spot a Competitive Advantage (Moat) in Any Business · Why a Thorough Industry Analysis Is Non-Negotiable

Criterion 3: Is Management Working for Shareholders?

A great business in the wrong hands can still be a poor investment. The most important thing a CEO does is decide what to do with the cash the business produces: reinvest it, buy other companies, pay down debt, pay dividends or buy back shares.

William Thorndike’s The Outsiders shows that the CEOs who created the most value were, above all, disciplined capital allocators. What to check: Share count over five years. Flat or falling is good.

Rising means your ownership is being diluted, often through stock-based pay. Where the free cash flow went. Add up ten years of acquisitions, buybacks, dividends and debt repayment from the cash flow statement.

Did those decisions earn good returns? Insider ownership. Managers with a large personal stake tend to think like owners.

Managers paid mainly on revenue growth or short-term earnings per share tend not to. Candour. Read three years of shareholder letters.

Does management admit mistakes and explain decisions in plain language? Having worked in investor relations, I can tell you that the tone of the letter is chosen carefully. Plain speaking about bad news is a strong signal.

Go deeper: How to Identify Great Management Before You Invest · The Hierarchy of Capital Allocation · Stock Buybacks Explained

Criterion 4: Is the Balance Sheet Sound?

Debt turns bad years into permanent losses. A business with no debt can survive a terrible year and recover.

A business with too much debt may be forced to sell assets, issue shares at the bottom or hand the company to its lenders. Your shares do not come back from that. The house thresholds: Net debt / EBITDA below 2.

0x. Net debt is borrowings minus cash. EBITDA is a rough measure of operating cash earnings.

Below 2x means the company could repay its debt with about two years of earnings. Interest coverage above 5x. Operating profit should cover interest payments at least five times over, so a 50% profit drop would still leave room.

Free cash flow covers the dividend. A company borrowing to pay its dividend is borrowing from its future. As Buffett often puts it, to finish first, you must first finish.

This criterion is how you make sure you are still in the game when the good years come. Go deeper: Long-Term Debt Explained · How to Read a Balance Sheet · Survival First

Criterion 5: Is the Price Reasonable?

Only now do we look at the price.

A wonderful business bought at any price is not automatically a wonderful investment. Pay too much and even a great company can deliver a decade of poor returns while the business itself does fine. Two simple tests: Free cash flow yield of 5% or more.

Divide free cash flow per share by the share price. A 5% yield on a business growing its cash flow means you start with a solid return before growth adds anything. A margin of safety of 25% or more.

Estimate intrinsic value conservatively — a simple discounted cash flow with modest growth — and aim to buy well below it. Graham’s margin of safety is what protects you from your own estimation errors. If a stock passes criteria 1–4 but fails criterion 5, it goes on your watchlist, not in your portfolio.

Great businesses do go on sale — during recessions, market panics and company-specific scares that turn out to be temporary. The watchlist is how you are ready when they do. Go deeper: What Is Stock Valuation?

· Price to Free Cash Flow · Margin of Safety Explained · When Is a Stock Cheap?

How to Run the Five Criteria on a Real Company

You do not need a finance degree or expensive software. A free source such as Yahoo Finance or Morningstar plus the company’s annual report is enough.

Here is the process I follow: Write the two-sentence description. How does this company make money, and why do customers choose it? If you cannot, stop.

Pull ten years of numbers. Revenue, operating profit, free cash flow, share count, total debt and cash. Put them in one spreadsheet.

Score criterion 1. Calculate ROIC and free cash flow conversion for each year. Mark pass, borderline or fail.

Score criterion 2. Name the moat source. Check whether ROIC and margins held up in the worst year.

Score criterion 3. Check the share count trend, insider ownership and where the cash went. Score criterion 4.

Calculate net debt / EBITDA and interest coverage. Score criterion 5. Calculate free cash flow yield and a conservative intrinsic value.

Write the bear case. Munger’s inversion: list the three most likely ways you lose money. If any is severe and likely, walk away.

Decide and record. Buy, watchlist or reject. Write down why in a decision journal so your future self can check your reasoning.

The whole thing takes one to three hours for a company you already understand. Most companies are rejected in the first twenty minutes, which is the point. Go deeper: How to Research Stocks: A Step-by-Step Guide · Stock Analysis Checklist · How to Use Yahoo Finance for Stock Research

Building Your Own Version

The Five Criteria is a starting point, not a cage.

Every great investor adapted the core ideas to their own temperament. Lynch looked for growth in everyday businesses he could observe. Fisher went deep on a handful of innovators.

Graham bought baskets of statistically cheap companies. What they shared was a written, consistent process — a clear philosophy, a repeatable research routine, non-negotiable criteria, rules for their own behaviour, and a habit of learning from mistakes. As you gain experience, you may tighten a threshold, add a sector-specific test or decide that certain industries are simply outside your circle of competence.

That is good. Write each change down with the reason. Your framework should evolve through evidence, not through whatever the market is excited about this month.

Common Mistakes When Using the Five Criteria

Scoring price first. You will find reasons to excuse a weak business. Always go in order.

Accepting one great year. Use five to ten years. Cyclical companies look brilliant at the peak.

Believing the moat story without the numbers. If returns did not hold up in a downturn, the moat is not proven. Ignoring dilution.

Earnings per share can grow while your slice of the company shrinks. Buying because it “almost” passes. Borderline on one criterion can be acceptable with a larger margin of safety.

Borderline on three is a no.

Your Next Step

Get the Five Criteria Checklist and run it on one company you already know — ideally one you own. You will learn more from scoring a single business honestly than from reading ten more articles. Then follow the path: start here if you are new, or go straight to how to research a stock step by step.