Thursday, July 10, 2014

Measuring Quality?

Some people use Return on Equity (ROE), others use Return on Invested Capital (ROIC) and there are still tons more of different metrics to use to measure "quality" in a company.

First, Quality as understood by me is not the financial strength or value of a company. Many people relate Quality to the balance sheet and solvency of a company. I see Quality as the ability of the company to generate large and consistent earnings. A good quality company is able to sell products with high margins.

To simplify is, Quality is the overall demand and price premium associated with its product.

Anyway, here are some interesting things about Quality that I found surfing the net.

Fidelity used ROA to measure Quality, while they acknowledge ROE and ROIC and alternative metrics as well. Their conclusion is that a quality-value metric is superior to either metric used alone.

Robert Novy-Marx wrote an interesting paper called "Value Investing". If you don't have the stomach and willpower to read the paper, that's okay. Greenbackd wrote a fantastic summary piece of it that recaps the basic message of the original paper - adding in quality helps value metrics.

The hardcore may want to read another paper written by Robert Novy-Marx called "The Quality Dimension of Value Investing". In it, he breaks down and elaborates further about adding the quality factor and the rationale for using Gross Profitability %. The Gross Profitability seems to be a very good measure of quality, despite it's simple calculation being (Revenue - COGS)/Total Assets.

The graphs, tables and results are really quite remarkable. I don't know about you, but I am definitely now a much bigger fan of incorporating such metrics into my stock selection toolkit.

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