The GuruFocus site gathers together a wide variety of information and calculations that investors can use to help determine whether or not investing in a specific stock is the right choice for them.
The GuruFocus Score is a exclusive stock performance rating system that has been found to be closely correlated with stock performance based on backtesting from 2006-2021. Two key components of the GF Score are the GuruFocus Financial Strength Rating and the GuruFocus Profitability Rating. These metrics use several criteria to determine the overall quality of a company’s balance sheet and its ability to generate profits, ranking them on a scale of 1 to 10, with 1 being the lowest quality and 10 being the highest quality. In general, companies with high financial strength and profitability ratings tend to be better investments due to their ability to generate profits with low risk. All numbers are as of the most recent quarter.
Financial strength
The GuruFocus Financial Strength Rating measures how strong a company's financial situation is based on the following factors:
1. The debt burden that the company has as measured by its interest coverage ratio for the most recent quarter. The higher, the better.
The interest coverage ratio measures how easily the company is able to make the interest payments on its outstanding debt. It is calculated by dividing operating income by interest expense. Benjamin Graham set a requirement of a minimum interest coverage ratio of 5 for the companies he invested in. An interest coverage ratio of 5 would mean that the company has enough funds on hand to make its next five rounds of interest payments.
2. Debt to revenue ratio. The lower, the better.
The debt to revenue ratio shows how much total debt (both short term and long term) the company has compared to its revenue as of the most recent quarter. The more revenue a company has in relation to its debt, the more financial freedom it has, and the less pressure it faces from existing debt obligation.
3. Altman Z-Score. The higher, the better.
The Altman Z-Score is a model meant to forecast the chances of business failure (bankruptcy) or financial distress up to two years in advance. When the Z-Score is less than 1.81, it is in the Distress Zone, meaning it is in danger of business failure. When the Z-Score is between 1.81 and 2.99, it is in they Grey Zone, meaning there is a chance of financial distress. When the Z-Score is greater than 2.99, it is in the Safe Zone, indicating that financial struggles are unlikely. The Altman Z-Score is calculated as follows:
“Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E,” where A = working capital / total assets, B = retained earnings / total assets, C = earnings before interest and tax / total assets, D = market value of equity / total liabilities and E = sales / total assets.
Profitability
The GuruFocus Profitability Rating ranks how profitable a company is and how likely it will remain profitable based on the following factors:
1. Operating margin. The higher, the better.
The operating margin is a percentage calculated by dividing operating income by revenue. A company with a higher operating margin is more efficient in its operations.
2. Piotroski F-Score. The higher, the better.
Developed by Joseph D. Piotroski, the F-Score evaluates companies based on a nine-point scale, with each point representing a characteristic identified as being correlated with better equity performance. Each of the nine points in the Piotroski F-Score is binary; either the company meets the criteria to get the point or it doesn’t. If the company meets zero to three of the criteria, it indicates poor business operation. A score of four to six indicates stable business operation, while a score of seven to nine means the operating conditions are very healthy. The nine tests are:
- Is return on assets positive?
- Is operating cash flow positive?
- Is change in return on assets is positive?
- Are accruals negative?
- Is change in leverage negative?
- Is change in working capital positive?
- Is change in share count negative?
- Is change in gross margin positive?
- Is change in asset turnover positive?
3. Trend of the operating margin (five-year average). A company with an uptrend in the operating margin has a higher rank.
Companies that can increase their operating margin over time are becoming more efficient in their business operations, generating more profits for each dollar invested.
4. Consistency of the profitability metrics.
The consistency of the profitability metrics refers to how stable the above three metrics are. Is the operating margin growing consistently, or does it plunge in one year only to rise sharply the next year? Is the Piotroski F-Score typically near the same level, or does it frequently change from quarter to quarter? The more consistent the profitability metrics, the more likely it is that the company is able to consistently generate profits.
5. Predictability rank.
The GuruFocus Business Predictability Rank is also a component of the profitability rating calculation. Using a scale of one to five stars, the predictability rank measures the strength and consistency of a company’s revenue per share and Ebitda per share over the past 10 fiscal years. According to the backtesting studies conducted by GuruFocus, a higher business predictability rank generally correlates with higher capital gains and lower risk of making a loss on a long-term investment.
Uses and pitfalls
GuruFocus’ Financial Strength and Profitability ratings can be very useful in terms of getting a general idea of the quality of a company. They provide a good starting point when screening the market for high-quality investment opportunities using the All-in-One Screener.
They can also provide a warning for investors if they are in the lower range. For example, if a company has a Financial Strength rating of three or less, it likely means that it is highly leveraged or struggling financially. A Profitability rating of three or less often indicates a company that has been losing money rather than earning profits.
Financial Strength and Profitability ratings in the four to five range can sometimes call business quality into question, but not always. At ratings of six or above, investors can typically have confidence in the quality of the business.
While the usefulness of these metrics comes from combining and simplifying multiple other calculations, it is this same quality that limits their usefulness in terms of more in-depth research. After all, the Financial Strength rating doesn’t tell you how the company’s cash compares to its debt, and the Profitability rating doesn’t tell you how fast revenue and earnings per share have grown in recent years. Investors will certainly have many other factors they wish to look at when conducting their due diligence on a potential investment.
Additionally, it is entirely possible for a company to have a Financial Strength rating of six or above and, say, an Altman Z-Score of less than 1.81, which would suggest the potential for bankruptcy. Likewise, it is also possible (though rare) for a company to have a Profitability rating of six or above and an operating margin in the negatives for the most recent quarter. Even if most of the criteria for these ratings are positive, driving up the ratings, other components may not be attractive. The criteria for the Profitability rating also include historical components, so if a company has been profitable for most of its history but has struggled recently, it could still receive a high Profitability score.
One last thing to note is that, like many other metrics that investors can use to evaluate publicly traded companies, the Financial Strength and Profitability ratings often aren’t really useful for recent startups, small-caps or financial stocks. Startups and small-caps often do not have sufficient data to calculate all of the components that make up these metrics. The same goes for financial stocks, which do not have Altman Z-Scores or operating margins. These types of investments require a different approach due to the relative lack of information available to the public.
