The Investing Department Quality Score

The Investing Department Quality Score is a 10-point framework used to evaluate businesses based on a combination of an evaluation of the story of the business and fundamental analysis. It looks at the industry, the company's market position, its financial statements, and the quality of management's decision-making.

This is both a qualitative and quantitative analysis. I look at the numbers as well as the qualitative factors that drive competitive advantage and market position. The goal is to weigh the narrative and the numbers because both matter.

When the narrative of the business and the numbers line up, that's great. But it isn't always the case. When they don't match, it doesn't automatically mean a stock is a great buy or one to run away from. It just means we need to identify why the numbers and the narrative don't agree, and decide from there.

Before you can understand a business, you have to understand the industry it competes in.

I look at how fast the industry is growing and how large it is. This analysis includes looking at the competitive forces: the major competitors, the barriers to entry, whether it's highly competitive or dominated by a few players. Getting a clear picture of the industry gives a reference point so analyzing the busienss happens with proper context.

This part of the process is usually straightforward. It only gets muddy when a business competes in multiple industries, making a peer to peer comparison difficult.

Once we understand the industry, we can then begin looking at where the business sits inside it.

How is the business differentiated? Can a competitor duplicate their product/service? Is it one of the dominant players? A worthy competitor? Or is it a newer, smaller business that's gaining market share fast? Sometimes you're looking at a disruptor, and you need to identify it by paying attention to the company's market position.

Revenue growth has to be referenced to two things: industry growth and the life cycle of the business.

For instance, a company growing revenues at 15% sounds great on the surface. But if its industry is growing at 20%, that company is actually losing market share to its competitors. Even what looks like a solid growth rate is an indicator the business might be a poor investment.

Next, is the business growing as it should? Where the business is in the business life cycle tells us what we need to know about revenue growth expectations. If a company is new and in the high-growth stage, I expect high revenue growth. If the company is mature, the expectation is lower revenue growth than when it was younger. I’ve learned that businesses should act their age. A mature company should perform like a mature company, and a young company should perform like an adolescent business.

If a company doesn’t “act their age”, then evaluation of why can’t be skipped. Why does a mature company suddenly show high growth? Why does a young company show stalled growth? These mismatches can be signs of great opportunities or signs of a company not acting its age and putting itself in a bad spot.

Revenue growth is about where the business is in its life cycle and where it sits within the industry.

Revenue growth is great. Revenue quality is just as important.

What "quality" means depends on the business. For subscription-based businesses, annual recurring revenue (ARR), retention, and how much customers spend year over year. For others, customer and brand loyalty and distribution may be the keys to evaluating revenue quality.

Take Adobe ($ADBE) for example. Their products are subscription-based and they pull customers into an ecosystem. Recurring revenue and retention are great signals for revenue quality.

Now compare that to Coca-Cola ($KO). No subscription model but they have an enormous distribution network and the strongest brand in their category. That brand loyalty plus distribution gives them very high-quality revenues.

The question this analysis answers is: can this business reasonably expect to consistently earn revenues in the future? It's not all about growth. It's about a competitive advantage which leads to consistency in revenues.

Gross profit margin is how much money left after a business delivers the product or service to the customer. Revenue minus the direct cost of delivering it. Net profit margins go further, capturing what's left after all expenses are paid.

These margins are compaerd to the rest of the industry. Revenue matters but if I earn more revenue than you and you keep more of your revenues after paying expenses, you might be the better operator. Some would say that's actually the stronger business.

Three things are evaluated:

Those three answers give a clear picture of how the business is performing on margins.

I want to know the cash generated from operations minus capital expenditures — that's free cash flow.

Capital expenditures represent required reinvestment to keep the business running, but they can also represent investments in the future. A great example is Amazon: a lot of their operating cash is being spent on building data centers right now. That spending is pulling free cash flow down.

A quality investment will generally have free cash flow that grows over time. Newer companies may not have much yet, operating at a loss, with cash coming from debt or equity. But for growing and mature businesses, actual cash coming in the door from operations is a must.

This section is about how a company is financed and how flexible its balance sheet is.

The most important metric here is debt to free cash flow. Basically, how fast a company can pay off its debt. Many companies fail when bad times come, not because the business was bad, but because they were over-leveraged. A properly leveraged company can survive a downturn because it can get debt off the books quickly and operate lean if it needs to.

Preferred companies have three years or less of free cash flow needed to pay off their debt. Five years or less is acceptable, just not the best position. Some industries, such as manufacturing, operate with more leverage because of heavy capital expenditure requirements, and that can still make sense for the business model.

Beyond debt-to-free-cash-flow, I also look at the broader balance sheet:

Cash is king. A company with more cash than it needs has flexibility and is typically a safer investment than a company that's running tight on cash.

I want to know what the company is doing with its share count. Are they buying shares back, or are they selling new ones?

A company that's selling shares can be a bad sign because it dilutes existing investors. Yes, authorizing and selling more shares brings in cash without an interest charge (like with debt) but with more shares outstanding, we own less of the same business.

There are reasonable exceptions. If shares are being sold at a rate that's much slower than the business is growing, the dilution may be insignificant in the long run. It can also make sense when a stock is extremely overvalued and management can raise cash cheaply to reinvest. It also makes sense for newer companies that need cash to support operations.

Young companies should sell shares only if they need to. I want mature companies to do it only sparingly.

What savvy investors really want to see is a company repurchasing shares. When a company repurchases shares, they're adding value for existing shareholder. Fewer shares outstanding means current own more of the business. A downward trend in shares outstanding is something that can add tremendous value to the shareholder.

Instead of answering, “is there a dividend or not?”, the goal is to focus on the dividend policy. Whether they are paying a dividend or not, whether they are growing their dividend at a high rate, does it makes sense for them to do that?

A company should be in at least a mature growth stage before paying a dividend. Early on, there are typically far better uses for cash: reinvesting back into the business, new product development, building a competitive advantage. Young companies paying a dividend are.

That said, "mature" isn't the only thing that matters — the nature of the business does too. Take Google. It's not a young company. But the type of business it runs has so much room for growth in new technologies, products, and services that it makes more sense for them to keep reinvesting rather than start paying a dividend. A mature company like Google not paying a dividend makes a lot of sense.

So I look at the dividend policy in context. What stage is the business in? What percentage of free cash flow are they paying out? Does it make sense for this specific business? And if there's no dividend at all, I ask whether that makes sense too.

Comparing the return on capital to the cost of capital will yield a metric that answers a very important question: Does this management team make the right decisions? The value spread lets us know how much value management is creating.

Like revenue growth, this number means nothing without comparing it to competitors. If a company's spread is consistently better than its peers, that tells me management's decision-making is consistently better than the competition.

I believe this is the best single metric for evaluating management. It tells me whether management is deploying capital the right way.

Valuation is something I look at separately. It's not part of the quality score.

A crappy business can have a high or low valuation, and a great business can be cheap or expensive at any given moment. Price reflects sentiment plus operations at a single point in time. Over the long run, stock prices should mirror earnings growth: a company that's consistently growing should trend up over time, and a company with declining earnings should trend down.

There's mispricing and anomalies in the market — that's just how the market works. Sometimes valuations don't make sense. That's why valuation has nothing to do with this quality analysis.

When I perform a valuation on a business, I use a discounted cash flow model with a five-year projection, with the terminal value typically mirroring the average free cash flow multiple. I also use price to free cash flow — market cap divided by free cash flow — to get an idea of valuation. I prefer cash flow over earnings, because cash flow isn't as easy to manipulate.

I am not an investment advisor. All information shared is my opinion. Seek an investment advisor for help making investment decisions. The Investment Department publishes content is for educational purposes only.