The 10 criteria for quality stocks
1. Revenue growth 10Y > 5% p.a.
The most fundamental measure. This metric considers the average revenue growth of the last 10 years (CAGR). In the long run, companies become more valuable when revenues and profits can be continuously increased.
Example Microsoft: In 2010, the company generated 62 billion USD in revenue. In 2020, the revenue amounted to 143 billion USD. Microsoft has therefore achieved an average annual revenue growth of 8.7%. The threshold of 5% is exceeded and there is a point in the Quality Investing (AAQS).
2. Revenue growth in the next 3 years
The future should be derived from the past. Here, we consider the average growth rate in the future based on consensus estimates from FactSet. Of course, one should not base any investment solely on the analysts' assessments, but these usually have a good perception and roughly indicate what the market expects. Here, we consider the three future years, as the company's value will heavily depend on future revenues.
In the best case, a company succeeds in achieving annual revenue growth of over 5% in both the average of the last 10 years and the expectations of the coming years. There is also a point in the Quality Investing (AAQS) for this. However, it is important that steadily increasing revenue is not of much value if the operating profits do not also grow steadily.
Example Microsoft: In 2020, the company generated 143 billion USD in revenue. Analyst estimates for 2023 amount to 198 billion USD. This implies an average revenue growth of 11.5%. This also exceeds the 5% threshold and is recorded with a point.
3. EBIT growth 10Y > 5% p.a.
Profitability at high sales. As with revenue, now we are looking at the past 10 years, but this time at the operating profit (EBIT). Ideally, a company manages to continuously increase its profit growth in line with revenue.
Often, with still unprofitable software companies, one can see that they have incredibly high revenue growth but only incur losses because they offer their product at steep discounts. Shareholders then receive very little of the growth and the customer rush.
Example Microsoft: Microsoft In 2010, an operating profit of 24 billion USD was achieved, which increased to 53 billion USD in 2020. This results in an average profit growth of 8.2%. This also adds a point.
4. EBIT growth in the next 3 years
Profit should grow with revenue. This ratio considers the average annual expected operating profit growth over the next three years.
Just like with revenue, an estimation provides a much better picture of market expectations. This is because the value of a stock is determined by all future cash flows, discounted to the present day.
Example Microsoft In 2020, the company achieved an operating profit of $53 billion. The estimates for 2023 amount to $78 billion, representing an average growth of 13.7%.
With these points, AlleAktien has created a solid foundation and it is already possible to filter out the companies that have not consistently grown throughout all market phases.
5. Debt < 4x EBIT
Eliminate indebted companies. A point is awarded here if the company's net financial debt is lower than four times the operating profit. The calculation proceeds as follows:
All interest-bearing liabilities (short- and long-term bonds, loans, etc.) minus the company's cash balance.
The advantage of this criterion is to filter out companies that are highly indebted. If the company is no longer able to cope with the accumulated debt (e.g. due to rising interest rates), it can quickly become dangerous for shareholders.
To stick with the example. Microsoft In 2020, Microsoft had long- and short-term financial liabilities amounting to USD 82 billion. The cash balance stood at USD 137 billion, making Microsoft not only debt-free but also having a net liquidity of USD 55 billion. This is a real showcase example and deserves the next point.
6. Profitable for 10+ years
Solid business model with strong moat in all market phases. For the next criterion, the company must have recorded a profit every year in the last 10 years. If a company has incurred an operating loss in any year, it will not receive a point. This also penalizes companies that were not well positioned in every market phase.
Here we also get Microsoft the next point. Every year has been completed with a positive result.
7. EBIT Drawdown 10Y < -50 %
Crisis-resistant. The operating profit (EBIT) must never have fallen by more than 50% compared to the previous record profit in the 10-year period. Only if this has been achieved, there is a point.
Example Microsoft: The company experienced the highest drawdown in 2016. Profit was 26.1% lower compared to the previous peak. The value was below 50%, earning Microsoft (US5949181045) the next point.
With the last three criteria, the Quality Investing (AAQS) aims to "punish" companies that have very cyclical or risky business models. This focuses on solid revenue and profit growth, supported by proper financing and stable earnings.
8. Return on Equity > 15%
For further growth, a high return on equity is necessary. If the underlying company is able to generate a return on equity of more than 15%, there will be an additional point.
When a company grows, new properties must be purchased, real estate must be built, machinery and equipment must be paid for, and employees must be hired. A high return on equity is necessary to finance these expenses.
The Calculation: Microsoft had equity of 118 billion USD in 2020, from which goodwill is deducted (- 43 billion USD), resulting in tangible equity of 75 billion USD. Now divide the net profit by tangible equity to obtain the return on equity (44 billion USD / 75 billion USD = 58.7%).
Hereby you receive Microsoft: Microsoft another point, as the company is very profitable and significantly above the threshold of 15%.
9. ROCE > 15%
Little debt. To avoid manipulation of the return on equity, one also examines the return on capital employed (ROCE). Although this is similar to the return on equity, it cannot be manipulated by high leverage. If the company operates with a lot of debt, it requires little equity, which may work well in good times with low interest rates, but can quickly become a problem in bad times.
When considering the overall return on capital, the operating profit is compared to the interest-bearing capital invested. The invested capital is the sum of the equity (equity minus goodwill) and the net financial debt. By calculating the return on invested capital, we obtain a meaningful indicator of the operational profitability of a company, regardless of its capital structure.
you can find all stocks with current prices and other important key figures. Our goal is to provide you with all relevant information so that you can make informed decisions. Our charts and diagrams help you track the development of individual stocks over time. We continuously update our data to ensure you are always up to date. Use our service and discover the Fair Value of your favorite stocks. Microsoft: So we subtract the net liquidity (55 billion USD) from the equity (75 billion USD), resulting in 20 billion USD as the invested capital. Now we divide the EBIT (53 billion USD) by the invested capital and obtain a ROCE of 265%.
Eulerpool
Here as well we provide Microsoft: an absolute peak value, thus scoring another point. The reason for this impressive result is conservative financing.
10. Return expectation > 10%
A good future return. If the expected return is above 10%, the company will receive a point for the tenth criterion. This is the only key figure that depends on the past price development.
The expected return is calculated using the IRR model. There are two main components: the Free Cash Flow yield and the annual EBIT growth.
To calculate the Free Cash Flow Yield, divide the Free Cash Flow of the current year by the market capitalization. The Free Cash Flow is the amount generated at the end of the year and available for discretionary use.
The second source of return is EBIT growth. The model assumes that the stock will be valued with the same multiple in the future. Therefore, the stock price must follow the increasing earnings in order to maintain the P/E ratio and valuation.
Microsoft: had a free cash flow yield of 2.8% in 2020. The EBIT growth of the next three years (13.7% p.a. (Expectation)) is now added to the free cash flow yield, resulting in an expected yield of 16.5% per year. With this, Microsoft (US5949181045) receives 10 out of 10 points and is considered an absolute quality company from the perspective of the Quality Investing (AAQS).
