Many investors think in terms of value. They scour financial statements trying to find undervalued opportunities.
Some focus on sales and earnings. The income statement shows these numbers as top and bottom line. But investors often miss some of the most valuable information. Let’s take a closer look at what that is…
First, we need to note that financial statements include three parts: income statement, balance sheet and statement of cash flows.
The income statement, which lists sales and earnings, gets most of the attention. It also shows the company’s expenses. The balance sheet shows what a company owns and owes. The statement of cash flows reveals how much cash management has for new opportunities.
Smart investors combine information from all three parts. This allows them to spot quality.
Quality means a company is well-managed. Good managers maximize profits. The company generates cash for management to allocate.
Now, there are really only three uses for cash in quality companies.
- Managers can reward investors with dividends or buybacks.
- They can invest in new companies.
- Or they expand operations.
High-quality companies provide stable returns to investors. And identifying quality requires us to dig deeper. It involves finding ratios in the data.
Understanding Ratios of Quality in Stocks
The simplest measure of quality is a company’s return on equity (ROE). It combines the income statement (earnings) with the balance sheet (equity). A high ROE shows that management is allocating capital efficiently.
The debt-to-equity (D/E) ratio shows how much money the company borrowed. This should be compared to the values of similar companies.
Different industries have different ratios. Some (like banks) rely on large amounts of borrowing. Others (like software) need little borrowing. This ratio needs to be compared to companies within its sector to spot high quality.
Total asset turnover indicates how efficiently a company uses its assets to generate sales. This is the ratio of sales to assets.
The days of inventory outstanding is the ratio of average inventory to costs. Days of sales outstanding is found in a similar way. So are days of payable outstanding. These ratios show how well management matches production to sales.
These ratios help identify companies relying on accounting gimmicks to boost earnings.
Gimmicks aren’t sustainable. However, they can make earnings growth look attractive to unsophisticated investors. This is why we need to consider quality factors when evaluating a company.
Combining Metrics to Amplify Results
Some investors combine metrics. They may want high quality and good value. These are stocks in companies with higher-than-average ROE and lower-than-average price-to-earnings ratios.
Others may want high quality and small size. Size is another factor that affects investment results. Combining size and quality can help spot tomorrow’s Tesla or Google.
Of course, no single factor works all the time. That’s why investors consider several factors when making decisions. Each factor provides unique information.
The quality factor emphasizes financial strength. It focuses on management. Value identifies how investors feel about the stock. Low valuation metrics can mean investors are pessimistic. Size shows potential for rapid growth. Momentum benefits from existing trends.
All of these factors can work together, and combining them can supercharge your investment results. In fact, that’s exactly what Adam O’Dell’s Green Zone Power Ratings system is designed to do for you.
This tool uses several of the stock metrics we’ve talked about here (such as Quality, Value and Size) to assign thousands of stocks of a specific rating (from 0 to 100) and help you determine which stocks are worth investing in.
Stocks with “Bullish” ratings are expected to outperform the market by 2X over the next 12 months, and “Strong Bullish” stocks by 3X. You can find the rating of more than 4,500 stocks by searching here.
But that’s just the tip of this tool’s potential because Adam has discovered a new way to maximize its power. He’s extracted certain factors within this ratings tool as part of his Infinite Momentum Alert for next-level investing.
His research shows that this strategy outperformed the market by 300-to-1 since 1999 by holding the top 10 stocks with strong Momentum, Quality and Value factor ratings and refreshing that list every four weeks.
And now he’s made this strategy available to you.
Adam launched Infinite Momentum Alert about a week ago. We’ve seen an incredible response to it, and due to such popular demand, the limited spots have quickly been filled.
However, because I don’t want you to miss an opportunity to join Adam on what is setting up to be an immensely promising strategy, I’ve talked to my publisher who’s agreed to open up access to it again — but just for one more day — to welcome in another wave of eager traders.
That said, here is your last chance to learn about Adam’s strategy and see his first list of stocks to buy so you can start following along right away. Go here to watch his presentation before it closes at midnight today.
Editor, Precision Profits