10+ Parameters to Define Stock Quality

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Stock Quality

The stock quality affects investment returns. Hence, there should be a mandatory check for stock quality. The quality of a stock may be good or bad. Sometimes, it may be very good or very bad.

Do you want to know the parameters which affect the stock quality?

In the present post, I am going to tell you 10+ parameters that affect stock quality.

10+ Parameters of Stock Quality

The following 10+ points are used to determine stock quality.

1. Debt to Equity Ratio (D/E Ratio) – The Most Important Parameter of Stock Quality

The debt to equity ratio of a stock is a significant metric. It is defined as the ratio of the total liabilities to the total shareholder’s equity. It is used to evaluate the financial leverage of a company.

Debt to equity ratio of a stock = Total liabilities of the company / Total shareholder’s equity of the company

It is a measure of the degree to which a company is able to finance its operations through debt vs. totally owned funds.

More particularly, it reflects the ability of the shareholder equity to cover all the outstanding debts in case of a downturn of the company.

A company’s balance sheet shows total liabilities and total shareholder’s equity.

You can read more about:

Company Balance Sheet

It is to be noted that:

Assets of a company = Total liabilities of the company + Total shareholder’s equity

The debt to equity ratio of a stock should be less than 1. If the debt to equity ratio of a stock is zero, it is very good. A company having a debt to equity ratio of zero is known as a zero-debt company.

Moreover, it is more essential to consider the sector or industry within which the company comes while using the debt to equity ratio.

The debt to equity ratio is a major parameter that affects the stock quality

2. Return on Equity (ROE)

The return on equity of a stock is the ratio of the net annual income of the company to its total shareholder’s equity. It is expressed as a percentage. It is a simple metric to evaluate investment returns. It gives an insight into how the company’s management is utilizing the equity to grow the business.

Return on equity (%) = (Net annual income / Total shareholder’s equity) x 100

As a thumb rule, if the return on equity ratio of a stock is at least 12%, it is good. If it is more than 20%, it is very good.

Moreover, a consistent increase in the value of return on equity over time means that the company is good at generating shareholder value.

In the same way, if the return on equity of stock consistently declines over time, the company management takes poor decisions to reinvest the capital.

The return on equity is a major parameter that affects stock quality.

3. Return on Capital Employed (ROCE)

The return on capital employed ratio is one of the profitability ratios in financial markets. It can be used to evaluate a company’s profitability and capital efficiency.

In another way, it helps to be aware of how well a company is producing profits from its capital.

The return on capital employed is defined as the ratio of the earnings before interest and tax (EBIT) to capital employed.

Here, capital employed = Total assets – Current liabilities

As a thumb rule, if the return on capital employed ratio of a stock is at least 12%, it is good. If it is more than 20%, it is very good.

Also read:

Financial Risk Ratios

The return on capital employed is one of the parameters that can affect stock quality.

4. Current Ratio (CR)

The current ratio of a stock is defined as the ratio of its current assets to its current liabilities. It is a liquidity ratio. This is a mandatory check for long term investors.

Current Ratio - Stock Quality

A higher current ratio of a stock is required. It should be greater than one.

Again, the current ratio of a stock should be higher than the industry average.

A stock’s current ratio of less than one may be an alarming signal to investors. Therefore, investors should be careful while selecting stocks.

5. Promoter Holding

The percentage of shares that are occupied by the promoters of a company is known as promoter holding.

Also, the investors should periodically check the stocks in which the promoters have raised their holding.

An increase in the promoter holding of a stock is a positive sign for investors. On the other hand, a decrease in the promoter holding of a stock is an alarm for investors.

The promoter holding in a stock should be a minimum of 20%.

6. Promoter Pledged Shares

Another parameter that is unseen by investors is the promoter pledged shares. It is the percentage of shares that are pledged by the promoter group.

The promoter pledged share percentage also affects long-term investment.

The promoter pledged shares of a stock should be less than 20%.

7. Market Capitalization

Market capitalization is the strength of a stock. It is an important factor in stock quality.

Market capitalization is the total market value of a stock, based on the outstanding shares. It is also referred to as “market cap”.

It is calculated by multiplying the total number of outstanding shares of a stock by the current market price (CMP) per share.

Top Market Cap Stocks - Stock Quality

Reference: BSE India

I have noticed that:

If the market cap of a stock is low, the liquidity is also low. That means you cannot easily buy and sell shares of the stock.

8. Earnings per Share (EPS)

Earnings per share a major financial parameter of a stock. It signposts the profitability of a company.

Earnings per share of a stock = A company’s net profit / Total number of outstanding shares

A higher value of earnings per share indicates that a company is more profitable.

9. Operating Profit

Operating profit is the profitability of a company before taking into account interest and taxes.

To calculate the operating profit, operating expenses are deducted from the gross profit.

For a good stock quality, the operating profit (5-year average) should be at least 10%.

10. Book Value Growth

First, you should know what the book value of a stock is. Then we will move to book value growth.

Let’s know the book value.

Book value is a company’s net asset value. It is found on a company’s balance sheet.

The book value and market value are two different things and are not the same.

A company’s actual growth is noticed in its book value. However, the market value is the price at which people are willing to buy. The market value is the demand price.

It is advisable to buy stocks when the market price is below their book value.

Many investors, including Warren Buffett, built their fortunes by buying stocks when the market price is below their book value.

The price to book ratio is used to compare book value and market value. A lower value of price to book ratio is a better one.

Book value growth expresses an investor on how rapidly a company is building its asset base.

A company may raise its book value by buying more assets or reducing its liabilities.

For a good stock quality, the book value growth (5-year average) should be at least 10%.

11. Total Debt Versus Net Current Asset

The total debt should be less than twice the net current asset value.

Good  Stock Quality

If the following conditions are satisfied, the stock may be considered as a good quality stock.

Market Cap: More than Rs. 100 Crore

D/E ratio: Less than 1

ROE: More than 12%

ROE of 5-year average: More than 12%

ROCE: More than 12%

ROCE of 5-year average: More than 12%

Book value of 5-year growth: More than 10%

EPS of 5-year growth: More than 10%

Operating profit of 5-year growth: More than 10%

Promoter holding: More than 20%

Promoter pledged shares: less than 20%

Current ratio: More than 1

Total debt should be less than twice the net current asset value.

Excellent Stock Quality

If the following conditions are satisfied, the stock may be considered as an excellent quality stock.

Market Cap: More than Rs. 1000 Crore

D/E ratio: Less than 0.5

ROE: More than 15%

ROE of 5-year average: More than 15%

ROCE: More than 15%

ROCE of 5-year average: More than 15%

Book value of 5-year growth: More than 10%

EPS of 5-year growth: More than 10%

Operating profit of 5-year growth: More than 10%

Promoter holding: More than 20%

Promoter pledged shares: less than 20%

Current ratio: More than 2

Total debt should be less than twice the net current asset value.

Low-Stock Quality to Avoid

If a stock has some of the given conditions, the stock may be a low-quality stock.

Very low market cap.

D/E ratio is very high i.e. high debt stock (generally higher than 2).

ROE and ROCE are very less or negative.

ROE and ROCE of the 5-year average are also very less or negative.

Book value, EPS, and operating profit of 5-year growth are very less or negative.

Promoter holding is low.

A higher percentage of promoter pledged shares.

The current ratio is very low.

Total debt is very high compared to the net current asset value.

Final Opinion

You should only invest in stocks that are either good quality or excellent quality. This is the first checkpoint for long-term investment. The stock quality significantly influences the long-term investment.

Do not trap by investing in low-quality stocks.

The second checkpoint is when to invest after you considered the stock quality.

The answer is simple. Invest only when the intrinsic value of a stock is higher than its current market value.

Use the intrinsic value calculator to find the fair of a stock.

Stock Intrinsic value calculator - Stock Quality

If you use any other parameters to determine the stock quality, please give your comments below.

If you find the post useful, please share it with your friends and colleagues.

You may also be interested to read:

The Best Way to Invest in Dividend Stocks

The Best Way to Find Intrinsic Value of Stock

Stock Intrinsic Value calculator (Using Book value and Dividend)


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