The very first step to find out whether a company suits as a potential investment, is to grade out its quality. One should not just invest in any stock that carries a cheap valuation, simply because it’s cheap. Most of the time they are cheap for a good reason. Rather the secret to long-term success is to collect high quality stocks at an attractive valuation. But different people have different definitions of quality. My personal quality criteria are summarized in five categories – dividend resume, growth, profitability, financial health and miscellaneous. Most importantly, I like to see strong fundamentals across these categories. Why? Because companies with strong fundamentals usually provide sustainable results in the long run.
I target businesses with increasing earnings, excellent profitability, clean balance sheet and strong amounts of free cash flow. These companies tend to not only be stable investments, but also typically put a lot of cash in their shareholder’s pockets in the form of dividends and stock buybacks. On the other hand, poor fundamentals are alarm signals. They indicate that the business is facing troubles or might face some troubles in the future. Above all, the quality rating gives me a first understanding of how excellent a business is, based on its fundamental aspects. I use it to separate the sheep from the goats.
The quality scoring system incorporates 20 metrics divided into five categories (each category has four metrics):
(1) Dividend resume
The dividend is a core element of my investment approach. I pick companies that reward their shareholders with sustainable increasing payouts. In return, I reward them with high scores in my quality rating.
I grade high yield companies with a higher score and vice versa. A yield below 1% is a show-stopper in my system.
Consecutive annual dividend raises
The rating rewards businesses with a long history of dividend increases. I require a company to increase its dividend at least five years in a row to make it into my DGI portfolio.
Dividend growth (5yr.)
The rating rewards businesses that provide a high dividend growth over those that provide a low dividend growth. A five-year horizon is the basis for the evaluation.
I favour businesses with a low payout ratio based on the earnings. A low payout ratio receives a higher score and vice versa.
(2) Growth metrics
In the end dividend growth will only be sustainable if the company is also growing its earnings over time. Increasing revenues and profits is music to the ears of shareholders. Especially for us dividend growth investors. Odds are high that a company will continue with its dividend policy if the earnings are growing.
Revenue trend (5yr.)
I like to see revenues that are steadily growing over time. The rating grades the historical revenue trend over the past five years.
EPS growth rate (5yr.)
I look at the historical earnings growth rate over the past five years. The higher the earnings growth rate, the better.
EPS trend (5yr.)
I reward companies whose EPS are trending upward and punish those whose EPS are trending downward.
Estimated EPS growth rate (3-5yr.)
I make use of estimates to grade a company’s ability to grow its earnings in the next 3-5 years. The higher the estimated earnings growth, the better.
Profitability metrics measure the ability of a company to generate earnings. Firms that do a good job of milking profits from their operations usually have a competitive advantage – a feature that normally translates into superior returns for investors. Thus I like to see a solid operating margin and return on equity when analysing the fundamentals of a business.
Operating margin (5yr. average)
I grade the average level of a company’s operating margin over the past five years. The higher, the better.
Operating margin trend (5yr.)
I reward companies whose operating margin is trending upward and punish those whose operating margin is trending downward.
Return on equity (5yr. average)
I grade the average level of a company’s return on equity over the past five years. The higher, the better. Note: a high ROE can be a result of hight debt load. I will also look at the debt level to see whether leverage is manipulating this metric.
Return on equity trend (5yr.)
I reward companies whose return on equity is trending upward and punish those whose return on equity is trending downward.
(4) Financial Health
Most of the companies borrow money to finance their operations. Especially when the price for money (interest rates) is low, it can even make sence to make use of it. This is absolutely fine. However too high debt load carries a risk for the overall business and for dividend investors in particular. Firms with excessive leverage might face a situation where they are forced to cut spending in order to reduce debt. As a result this can affect the dividend policy. Dividend payment might be reduced or suspended. Consequently I reward companies with a strong balance sheet and cash flows to take account of this risk.
I grade the debt/capital ratio of the most recent quarter. The lower the debt/capital ratio the better.
Debt/Capital trend (5yr.)
I reward companies whose debt/capital ratio is trending downward and punish those whose debt/capital ratio is trending upward.
Free cash flow trend (5yr.)
Free cash flow states how much cash is available after cash outflows to support operations and capital expenditures. I like to see growing free cash flow over time. Thus I reward companies whose free cash flow is trending upward and punish those whose free cash flow is trending downward.
Interest coverage ratio (EBIT/Interest) measures how easily a firm can cover interest on its outstanding debt. The higher the interest coverage the better.
Under miscellaneous I’ve summarized four metrics to value the general quality and risk of a business:
S&P Credit Ratings
Standard & Poor’s is a well-known international credit-rating agency. S&P issues a credit rating which is a forward-looking opinion about the overall creditworthiness of a business. It grades entities from AAA (highest credit rating) to D (lowest credit rating). I reward firms that have a high credit rating and punish those that have a low credit rating. In general, companies that are rated below investment grade (worse than BBB-) do not qualify for my DGI portfolio.
Morningstar MOAT Rating
Morningstar is a well-known independent investment research company. Its famous moat rating values a company’s sustainable competitive advantages. That is to say, a company with an economic moat can fend off competition and earn high returns on capital for many years to come (source: morningstar.com). Therefore I consider the economic moat rating when analyzing a business and reward those companies with a good moat rating.
Shares outstanding trend (5yr.)
Some firms buy back its own shares to reduce the number of shares available in the market. Investors highly appreciate stock repurchases. For good reasons. First, it boosts the EPS, since the earnings are spread among less available shares. Second, with a shrinking share count a company should be capable to pay and raise dividends more easily. A point which is highly attractive to dividend growth investors. Finally, buy backs demonstrate a company’s confidence into its own business. The management might believe that the stock is undervalued at the current price level. That is why I reward companies whose average share count is decreasing over time.
Beta is a measure of volatility of a stock, compared to the whole market. A beta of 1 indicated that the stock price moves with the market. A beta of less than 1 means that the stock is less volatile than the market and vice versa. Subsequently I reward companies that are less volatile and punish those who are more volatile.
I sum up the grades of all metrics to derive the final quality rating result. Depending on the scores achieved, a stock can receive a five-star rating (excellent quality), four-star rating (good quality), three-star rating (average quality), two-star rating (poor quality) and one-star rating (fail). It goes without saying that five-star and four-star stocks represent future potential investments. In addition, the quality rating of a stock is independent from its valuation. A company of excellent quality might be way too overpriced. In this case it would not represent an attractive investment. That is why I check the valuation in a separate rating.