While the exact formulas that we use to determine the Quality of a company are proprietary, we can give some guidance on what we are looking for with these formulas
In the most general sense, we look for companies with strong and steady revenue and earnings growth, management efficiency, and skill in managing company resources
The most prominent part of the Roster is the 1 - 10 rating rating that shows up in Take Stock, in the Roster of Quality portfolio, and the First Impression. This number is based on two primary factors, Growth and Efficiency:
The Growth Index evaluates the most important attributes of the company's annual sales and earnings growth over a period of up to ten years and rates that composite on a scale of 1 to 10 with 3.4 being the minimum and 6.7 or above being desirable.
The Efficiency Indicator reflects management's ability to continue its record of healthy sales and earnings growth by assessing how carefully management makes use of the resources it has to work with.
The significance of growth.
A company's ability to earn money for its stockholders is the key to the price they're willing to pay for its stock. Investors often express the price of a share of stock in terms of the company's earnings. The term "multiple," or "PE" (price/earnings ratio) defines that relationship and is simply the price one pays for each dollar of a company's earnings per share-much like what you would pay for a gallon of gas or a pound of coffee. This makes it easy to judge the value of a share of stock-not by how much you pay for the stock (or tank of gas), but how much you pay per dollar of earnings (or gallon of gas).
If you can buy a share of stock of a good quality company at a reasonable multiple of its earnings, and can hold it as its earnings grow year after year, you can sell it for the same-or an even higher-multiple of its earnings and make money.
Why Efficiency is important.
Analyzing growth is not enough. It's also important to assess management's efficiency and effectiveness to be confident in its ability to sustain that growth.
Profit margins-the percent of every dollar of sales the company gets to keep after paying its expenses-can show you how efficiently management spends expense dollars. Steady profit margins, for companies that are turning in good results and are likely operating at or near peak efficiency, or increasing margins, where management is responding to a need for improvement, are signs of good management.
A declining trend in profit margins is the result of rising expenses compared with sales, and would suggest that management was not "minding the store" as well as perhaps it should.
Experienced investors may be able to identify some scenarios where declining profit margins are okay; but the beginning investor should definitely shy away from companies with decreasing margins.
Return on Equity
A second though less important indicator is the Return on Equity (ROE).
Return on Equity-the percent of profit the company makes for every dollar of its shareholders' investment-is based on longer-term decisions whose results will actually show up later in the profit margins. ROE can serve as a caution flag if it differs substantially from earnings growth. Trends aren't necessarily meaningful-especially if earnings have been growing at greater than a sustainable rate.