Both academicians and practitioners have strived to gauge the 'quality' of companies in various ways over the years.
However, the use of quality as a factor is quite recent with a large proportion of academic literature pertaining to it having been published in the last couple of decades. Even among these, recent work has been the most impactful, introducing well defined quality factor investing strategies.
One of the first quality related market inefficiencies was identified by R G Sloan in his paper titled "Do Stock Prices Fully Reflect Information in Accruals and Cash Flows about Future Earnings?" (Sloan, 1996). This study found that investors typically focused on earnings and ignored the signals contained in accruals and cash flows when making investment decisions. This conclusion encouraged a body of research that strove to look beyond value as a factor, complementing it with some "forward looking” tools.
More recently, in his seminal paper "Quality Investing", Robert Novy-Marx introduced Gross Margin or gross profitability as a persistent measure of quality (Novy-Marx, 2013) as well. Another important paper “What is Quality?” by Hsu, Kalesnik and Kose combined and summed up all the characteristics of Quality (Hsu et al., 2019) in following categories:
- Capital Structure
- Accounting quality
These characteristics of quality can be measured using various metrics. Due to the subjectivity inherent to the understanding, characteristics and measures of quality, researchers have found the freedom to use the metrics and also combinations of metrics to measure those aspects of ‘Quality’ that are congruent with their proprietary definitions of it.
As is the norm, each measure can be used and interpreted in multiple ways. Measures for a company can be compared with their own historical values or used for comparison to sector and industry peers.
|Profitability||Return on Equity (ROE)
Return on Capital Employed (ROCE)
Return on Assets (ROA)
|Capital Structure||Debt to Equity (D/E) Ratio|
|Accounting Quality||Accrual Ratio|
|Investment||Growth in Total Assets (Capital Expenditures)|
Corporate profitability is the most indispensable component of long-term capital appreciation in the equity markets. A company’s profits are its reward for shareholders who provide it with risk capital to fund its operations. Higher profit margins facilitate growth as the surplus capital available can be utilised for expansion and reinvestment. However, as a measure of Quality, the definition of "profit" must be expanded to include a company’s ability to generate a return on the entire capital used by it, and not just that attributable to shareholders. It must also take into account the value of its assets to ascertain whether its profits are adequate reward for continuing to own those assets. As mentioned earlier, Return on Equity (ROE), Return on Assets (ROA), and Return on Capital Employed (ROCE) are common measures for profitability.
Return on equity (ROE)
The ROE is a measure of the profitability of the company that is attributable to its shareholders/equity-holders. It measures the return generated by a company on the book value of the funds provided to it by shareholders. It is calculated as follows
ROE = Profit After Tax (PAT) / Shareholder Equity
Shareholder Equity = Total Assets - Total Liabilities = Paid up Share capital + Reserves and Surplus
Since, ROE is calculated on a net income basis, it takes into account the impact of a company's financing decisions - interest payable on debt - on its shareholders’ earnings. Higher ROE companies are preferred to low ROE ones and higher the spread between the company’s ROE and its cost of equity, greater the potential for value creation.
Return on Capital Employed (ROCE)
ROCE is a pre-tax measure of profitability for a company and it evaluates a company’s efficiency in utilising the capital that it raises to generate returns for all its capital providers i.e. debtholders and shareholders. It is measured as follows
ROCE = Earnings Before Interest and Tax (EBIT) / Total Capital Employed
Total Capital Employed = Total Assets - Current Liabilities*
Companies that generate a higher ROCE are preferred to those that generate a lower ROCE. Since it measures profitability on a pre-tax, pre-interest basis, ROCE is a useful tool to compare companies’ profitability and efficiency across different sectors and industries with varying capital structures.
*The definition of the Total Capital Employed is inherently subjective in nature. While some analysts and professionals define Total Capital Employed as shown above, some may measure it as the sum of Book Value of Equity (BVE) and Total Liabilities (which would also include short-term debt/liabilities)
Return on Assets (ROA)
ROA is typically used as an alternative to ROCE when analysing predominantly financial companies. Since the borrowings of a financial company are part of its operating structure and interest expenses an integral part of its operating costs, using ROCE for such companies has the poetnetil to mislead. It is measured as follows
ROA = Profit After Tax (PAT) / Total Assets
Companies with higher ROA than their peers are considered to be of higher quality since they are able to generate higher returns using their assets. ROA is specifically an extremely useful measure to gauge a bank or a lender’s efficiency in capitalising its loan book (primary asset base) to generate returns for its shareholders.
Growth is also an important element of quality. It is intuitive that companies with high and sustainable growth prospects will generate higher returns for their shareholders. Although growth as a term is modestly open-ended, growth is most commonly defined as either the growth in a company’s revenues or earnings.
Revenue is the topline of any company’s income statement / P&L and refers to the total proceeds that a company receives through the sales of its goods and/or services. Revenue Growth It is commonly calculated as an average of growth over more than a reporting period. The most common definition is
Revenue Growth = Average of 3 year Revenue Growth
Companies growing their revenues consistently and sustainably ensure that they effectively capitalise on their investments and add value to their shareholders.
Earnings Per Share (EPS) Growth
EPS indicates how much of a company’s total net income is attributable to one common equity share. Like revenue growth, it is commonly calculated across more than one reporting period. The most common definition is
EPS Growth = (EPS in year T - EPS in year T-3)/EPS in year T-3
EPS = PAT / Total number of shares outstanding
Analysing net income in isolation does not take into consideration the effects of dilution through additional equity issuances or conversion of other dilutive securities (stock options, convertible bonds). EPS addresses this deficiency.
Companies with higher EPS growth are preferred to those with lower EPS growth. However it is important to ensure that a company’s EPS growth is sustainable, otherwise its value generating effects may fade over time.
The capital structure of a company indicates the manner in which its operations are financed and its resilience to foreseeable and unforeseen challenges. It refers to the composition of its total capital between owned capital, which is shareholder equity, and owed capital or borrowings. The proportion of debt in relation to shareholders’ equity is termed as its "leverage".
Studies show that companies with sustainable and stable leverage tend to generate excess return for their shareholders in the long term.
Companies that strike a balance between debt and equity in the capital structure and ensure that the value enhancing effects of leverage are reaped without jeopardising its long term sustainability are considered as high quality companies. The most common measure of this sustainability is the Debt to Equity Ratio
Debt to Equity (D/E) Ratio
The D/E Ratio is a measure of a company’s leverage and is calculated as follows
D/E Ratio = Total Debt/Total Equity
Highly leveraged companies are considered as extremely risky for their shareholders, since the burden to pay interest on their borrowings is high and may be uncorrelated with their earnings. This can result in a company’s existence being jeopardised in difficult times. However, different sectors and industries can employ very different capital structures based on their operating environment and revenue visibility. As a result, the D/E Ratio is better suited to a relative comparison with similar companies.
Accounting is governed by multiple accounting standards, some of which allow subjectivity depending on the sector and industry involved. Frequent changes in the accounting treatment of significant accounting heads and aggressive interpretation of applicable standards are typically considered undesirable.
In addition, an array of forensic tools have emerged over the years that use advanced statistical techniques to determine the veracity of a company's accounts. The most commonly used measures in this category are the Accrual Ratios.
Accruals refer to those expenses/income that are recorded on a company’s income statement but do not generate a cash outflow/inflow when they are recorded. They refer to adjustments for revenues that are earned but are not yet received and expenses that are incurred but not yet paid for. While necessary to get a correct picture of a company's performance, they are prone to subjectivity and consequently, possible manipulation of earnings. There are two Accrual Ratio in common use. These are the Cash Flow Accrual Ratio (CFAR) and the Balance Sheet Accrual Ratio (BSAR). The CFAR is calculated as follows
CFAR = (PAT - FCF) / Total Assets
If a company generates more cash than its reporting profits, cash earnings are higher than those based on accruals and the CFAR returns a negative number, which is considered good. It indicates higher persistence in earnings. On the other hand, if the CFAR is positive, it indicates that future earnings may drop.
The other Accrual Ratio, the BSAR is calculated as follows
BSAR = Change in Net Operating Assets /Average Net Operating Assets
Net Operating Assets = Total Assets - Cash & Short Term Investments and
Average Net Operating Assets = (Opening Net Operating Assets + Closing Net Operating Assets) / 2
An increase in earnings accompanied by a positive CFAR and a high BSAR is typically a sign of low quality earnings.
The efficacy of this approach has been borne out by academic research as well, especially in a detailed study on Accrual Reliability, Earnings Persistence and Stock Prices by Richardson, Sloan, Soliman and Tuna (Sloan, 1996, #).
Growth in total assets
In their 2008 study, Cooper, Gulen and Schill (Cooper et al., 2008, #) provided evidence that the total asset growth rate of a company can be a strong predictor of abnormal future returns. Their findings indicate asset expansion, organic or inorganic, are typically followed by periods of abnormally low returns. On the other hand, asset contractions are typically followed by high return periods. Growth in Total Assets is calculated as follows
Growth in Total Assets = (Total Assets in T Year - Total Assets in T-1 Year)/Total Assets in T-1 Year
While the profitability screen in the earlier section is intuitive, the low investment phenomenon is counter-intuitive and often considered to be dubious by many academics and professionals because companies that refrain from growing their asset base may not do well over the long term. To that extent, this measure is best used as a relative indicator to a company’s own history and in comparison to others in the same sector or industry.