Key quantitative metrics to identify high quality companies

When investing in the stock market, we're purchasing parts of a company with our current funds, aiming to increase their value over time. This can be achieved in multiple ways: focusing on short-term market trends, known as speculation, or investing in companies whose future prospects we believe will improve (e.g., increased revenue, market share, etc.) and holding them long-term. Value investing comes into play when we buy these promising companies at a lower price than their perceived worth. In today's post, we won't delve into valuation (saving that for future publications) but instead, we'll explore some financial metrics that can act as a preliminary filter to identify high-quality companies. However, please note that before making a final decision to invest in a company, it's crucial to conduct a deeper analysis, focusing on its competitive advantages, often referred to as MOATs. We'll address this topic in another post.

So, which financial metrics allow us to identify high-quality companies?

• Does the company grow revenue and Earnings-Per-Share (EPS) faster than its competitors? Does it have greater Return-On- Invested-Capital (ROIC)? What about Earnings-Before-Interest-Taxes (EBIT) margins? If increasing, it might indicate that the company is gaining market share against competitors.
• Has the company increased or reduced the number of shares over time?
• Is the company's ROIC higher than its Weighted-Average-Cost-of-Capital (WACC)? Otherwise the more you reinvest the more money you lose.
• ROICs higher than 12% are usually a sign of good company. Apart from having high ROICs, it is important that the company has a high reinvestment rate, since the expected growth rate in operating income is a byproduct of the reinvestment rate and the (ROIC).
• Same with EBIT margins higher than 12%.
• Are EPS and EBIT margins stable or increasing? Otherwise, it might indicate that the company is cyclical.
• How has the company's price evolved over time? If after 10 years the price remains the same, there are big chances the company is performing poorly (perhaps management isn't treating shareholders well enough. We'll delve more into this in the post about MOATs).
• What about debt? If the Net Debt / EBITDA ratio is higher than 3x, it might indicate the company is overleveraged, posing a terminal risk in recessions or periods of high-interest rates. The Debt / Equity ratio also depends on interest rate values, but usually, a good value is under 35%.

It's very difficult to find a company that meets all these requirements, and if you do, it might trade at very high multiples (i.e., it might be very expensive). An example of such a company might be Hermès ($RMS), the luxury brand, which trades at 55x NTM PE at the time of writing.

Another important point to bear in mind is that you can find quality companies in all types of sectors, even in cyclical and low-quality ones. An example is Ryanair in the aerospace industry. And actually, these kinds of companies are usually a good option since, as Peter Lynch explains, 'in bad industries, the weak might drop out and the survivors get a bigger share of the market'.

We do not seek to find tomorrow's winners – rather, to invest in companies that have already won.

Terry Smith, Fundsmith fund founder.

Example of financial analysis

Below, you can find a preliminary analysis I have carried out for some popular high-quality companies using the metrics explained above:

Note: I have considered CAPEX/Revenue as a proxy for reinvestment rate since it is way easier to compute. Please note that this metric doesn’t make much sense for Autodesk since it is a software and asset-light company, but does show how Nike is in a much more mature state (and therefore has less reinvestment possibilities) than Tesla.

Stock market price correlation factors

Finally, one last interesting realization: the price evolution of a stock in the stock market usually correlates with EPS evolution + annual dividend paid by the company + valuation multiple evolution. That is, if you bought 10 years ago a company X that was doing 1$ EPS and today it is doing 6$ EPS, considering that the company has given a constant annual dividend of 1% and that 10 years ago it was at 20x PE ratio and today it is at 15x (since there is more negativity in the market sentiment), then the price of that stock has probably increased by 4.89 times by now. Why? Annual CAGR of 20.62% (adding the 1% annual dividend) minus the 25% discount in the valuation multiple compared to the past.

It looks obvious then, that in the long-term, the fundamentals of the business are way more important than the valuation multiple (which however can be of major importance in the short-term).