TSCO
Last week we rolled out a new methodology for arriving at the A+ Quality Grade.
Previously, the Quality Grade used a combination of five components to assess the “quality” of a particular stock. A higher quality stock possesses traits associated with upside potential and reduced downside risk. The components of the prior Quality Grade calculation considered management’s financial decisions (accruals and change in asset turnover), whether the interests of shareholders are being recognized (share buybacks and dividends) and whether analysts are more optimistic than they were previously about the stock (earnings estimate revisions).
The new A+ Quality Grade is the percentile rank of the average of the percentile ranks of return on assets (ROA), return on invested capital (ROIC), gross profit to assets, buyback yield, change in total liabilities to assets, accruals, Z double prime bankruptcy risk (Z) and F-Score. The score is variable, meaning it can consider all eight measures or, should any of the eight measures not be valid, the remaining measures that are valid. To be assigned a Quality Score, though, stocks must have a valid (non-null) measure and corresponding ranking for at least four of the eight quality measures.
To ensure the validity of the factors used for the revised Quality Grade, we backtested the results of the new scoring system across all letter grades (A to F) for the period of 1998 through 2019.
Here are the results:
As we would expect, moving from Quality Grades of F to D to C to B to A resulted in better cumulative returns for each higher grade.
Here are the expanded valuation measurements used for the Quality Grade taken from the Stock Evaluator page for Tractor Supply Co. (TSCO):
The “Score” for each of the eight variables used for the Quality Grade is the percentile rank for the company. So, for example, Tractor Supply ranks in the 94th percentile for return on assets (ROA) as of the close on Thursday, October 29. The TSCO column shows the actual value for the company for each of the eight metrics. So Tractor Supply’s ROA was 12.2% as of the close on October 29. The Sector Median column displays the median values for the company’s respective sector. In the case of Tractor Supply, the median or midpoint ROA for the companies in its sector (other specialty retailers) was –1.2% as of October 29.
Beyond taking the average of percentile ranks for the eight variables now used for the Quality Grade, the final letter grade is based on the percentile rank of that average. For Tractor Supply, the average score for its eight quality variables is 71.4 as of October 29. To have a more uniform distribution of letter grades, we then take the percentile rank of the average score. So Tractor Supply’s average score of 71.4 ranks in the 95th percentile for all stocks in the A+ Investor universe as of October 29.
Return on Assets
Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA offers an indication of how efficient a company’s management is at using its assets to generate earnings. The higher the ROA number, the better, because the company is earning more money on less investment in assets.
Return on assets is determined by dividing net income for the most recent 12 months by total assets and is displayed as a percentage.
Return on Invested Capital (ROIC)
Return on invested capital (ROIC) is a profitability measure that calculates the profit that a company generates from long-term sources of company funding that have provided capital. Invested capital can be provided by both bondholders and shareholders. Subpar ROIC can suggest poor capital allocation or an inability by management to deploy capital effectively.
For the purposes of the Quality Grade, the numerator of the equation measures a company’s earnings before interest and taxes (EBIT), also referred to as operating income, while the denominator measures the sum of net working capital and net fixed tangible assets.
ROIC is displayed as a percentage.
Gross Profit to Total Assets
A company’s gross profit is calculated by subtracting the cost of goods sold (COGS) from sales to arrive at gross income. This figure is then divided by total assets.
Gross income represents the amount of profit a company earns by selling its products or services. Cost of goods sold is the cost a firm incurs by manufacturing or producing an item, such as material and direct labor costs. Gross profit reflects a firm’s basic pricing decisions and its material costs. The greater the gross profit and the more stable it is over time, the greater the company’s expected profitability.
By comparing gross profit to assets, investors are getting a snapshot as to whether the firm’s assets are profitable. Since the profitability test is measured so near the top line, it is considered a very clean measure of economic profitability.
Generally, the higher the gross-profit-to-assets ratio, the better.
Buyback Yield
A stock’s buyback yield is determined by comparing the average shares outstanding of a fiscal period with the average shares outstanding of another fiscal period. In this case, we are comparing the average shares outstanding for the latest fiscal quarter to the average shares outstanding in the same fiscal quarter a year ago.
According to economic theory, an investor should be indifferent to dividends or buybacks. Dividends return cash to shareholders. Buybacks increase ownership, giving shareholders a bigger claim to future earnings and larger dividend payments—assuming dividend payout ratios are unchanged and net income is essentially stable. Shareholder yield plays into this concept. Shareholder yield is the sum of the dividend yield (dividends divided by share price) and the buyback yield (the percentage change in the number of shares outstanding). Companies with positive levels of shareholder yield outperform companies with negative levels of shareholder yield.
If a stock has 90 million average shares outstanding in the latest fiscal quarter and had 100 million average shares outstanding for the same quarter a year ago, the buyback yield would be 10%. Conversely, if a stock has 100 million average shares outstanding in the latest fiscal quarter and had 90 million average shares outstanding in the same quarter a year ago, it will have a buyback yield of –11%. Note that the sign is reversed, so that a positive buyback yield indicates the average number of shares outstanding declining while a negative number indicates the average number of shares outstanding is increasing.
The percentile rank notes the percentage of buyback yield in the universe of domestically traded companies with a buyback yield that is equal to or lower than it. For example, a buyback that is greater than 75% of the stocks with a valid buyback yield is said to be in the 75th percentile, where 75 is the percentile rank.
The higher the percentile ranking a company has for buyback yield, the greater the percentage of shares outstanding it has repurchased over the last year.
Change in Total Liabilities to Total Assets
To arrive at the change in total liabilities over the last year, the ratio compares the level of total liabilities of a company for the latest quarter to that of the same quarter a year ago. The difference is then divided by total assets for the last fiscal quarter and is presented as a percentage.
Dividing the net change in total liabilities by total assets “scales” it by company size, making it comparable across companies.
The higher the percentile ranking a company has for the change in total liabilities scaled by assets, the greater the decline in total liabilities relative to assets over the last year. The percentile rank ranges from 0 to 100, with 0 signaling the least favorable and 100 signaling the most favorable.
Accruals to Total Assets
This ratio tracks the difference between net income and income from operations over the last 12 months (net income minus cash from operations) and then divides that difference by the total assets for the last quarter.
Accrual accounting requires transactions to be recognized based on when they occur as opposed to when cash changes hands.
It is preferable for a company to have cash flow from operations that is greater than net income before extraordinary items (making this ratio negative). The measure tries to avoid firms making accounting adjustments to earnings in the short run that may weaken long-term profitability.
Dividing accruals by total assets “scales” it by company size, making it comparable across companies.
The higher the percentile ranking a company has for the accruals-to-total-assets ratio, there is a perceived higher quality to the company’s earnings. The percentile rank ranges from 0 to 100, with 0 signaling the least favorable and 100 signaling the most favorable.
Z Double Prime (Z) Bankruptcy Risk
This measure was developed by Edward Altman, a professor emeritus at New York University’s Stern School of Business. He created the Z-score model to assess the financial riskiness of a company. The original model was built almost 50 years ago based on balance sheet, income statement and stock price data for publicly traded manufacturing companies. A new model, Z double prime was developed for not only private companies but also companies in other industrial sectors like retail, wholesale, service, energy and public utilities.
Z Double Prime = 3.25 + (6.56 × A) + (3.26 × B) + (6.72 × C) + (1.05 × D)
Where:
The ranges for a firm’s Z double prime score are:
The higher the percentile ranking a company has for Z double prime, the less apt it is to face insolvency. The percentile rank ranges from 0 to 100, with 0 signaling the least favorable and 100 signaling the most favorable.
F-Score
The F-Score is a discrete score from 0 to 9 that reflects nine criteria used to determine the strength of a firm’s financial position. The F-Score was created by University of Chicago Professor Joseph Piotroski, who devised the scale according to specific aspects of a company’s financial statements. The F-Score was originally developed to determine the best value stocks, with a score of nine being the best and zero being the worst.
For every criterion met (noted below), one point is awarded; otherwise, no points are awarded. The points are then added up to determine the highest level of financial strength.
Return on Assets. As a first step in determining whether a company is financially distressed, the Piotroski F-Score requires that the return on assets (ROA) for the most recent fiscal year be positive. Return on assets examines the return generated by the assets of the firm and is calculated by dividing net income by total assets. A high return on assets implies that the assets are productive and well-managed.
Operating Cash Flow. In addition to return on assets, the operating cash flow for the most recent fiscal year must also be positive. This eliminates companies that are burning through their cash and therefore are more likely to be financially distressed.
Change in Return on Assets. The next requirement is that return on assets for the most recent fiscal year must be greater than return on assets for the previous fiscal year. A company can increase return on assets by boosting its profit margin or by using its assets to increase sales (or both).
Accruals. The next requirement addresses the relationship between earnings and cash flow levels—accruals. Piotroski seeks companies that have cash flow from operations greater than net income before extraordinary items. The measure tries to avoid firms making accounting adjustments to earnings in the short run that may weaken long-term profitability.
Change in Leverage. Piotroski measures change in leverage as the historical change in the ratio of total long-term debt to average total assets. For our purposes, we have also added in short-term debt to the numerator because many companies include the current portion of long-term debt in this figure. The higher the figure, the greater the financial risk.
Change in Liquidity. As an additional test of firm solvency, the current ratio for the current fiscal year must be greater than the current ratio for the previous fiscal year. The current ratio is defined as the ratio of current assets to current liabilities at fiscal year-end. A high current ratio indicates a high level of liquidity and less risk of financial trouble.
Equity Offering. Similar in concept to an increase in long-term debt, financially distressed companies that raise external capital could be indicating that they are unable to generate sufficient internal cash flow to meet their obligations. Additionally, if a company issues stock while its stock price is likely depressed (has a low price-to-book ratio), it highlights the company’s weak financial condition. We measure an equity offering by assessing if the company has maintained or reduced the average number of outstanding shares during their last fiscal year. Therefore, shares outstanding for the most recent fiscal year must be less than or equal to shares outstanding for the previous year.
Change in Gross Margin. Gross profit margins reflect the firm’s basic pricing decisions and its material costs. Gross income or profit is measured as revenue less the company’s cost of goods sold. Gross margin represents the proportion of each dollar of sales that the company retains as gross profit. Piotroski feels that an improvement in margin signifies a potential improvement in factor costs, a reduction in inventory costs or a rise in the price of the firm’s product. The change in gross margin is defined as the firm’s current gross margin ratio (gross income divided by total sales) less the prior year’s gross margin ratio. The Piotroski F-Score requires that the gross margin for the most recent fiscal year be greater than gross margin for the previous fiscal year.
Change in Asset Turnover. The final element in Piotroski’s financial scoring system adds a point if asset turnover for the latest fiscal year is greater than the prior year’s turnover. Asset turnover (total sales divided by average total assets) measures how well the company’s assets have generated sales. An increase in the asset turnover signifies greater productivity from the asset base and possibly greater sales levels.
The higher the percentile ranking a company has for the F-Score, the higher the perceived financial strength of the company.
If you have any questions or comments about this week’s topic, or have anything to say about A+ Investor, reach out to me directly at wayne@aaii.com.
