GRADE & SCORES OVERVIEW
This brief guide is an informal introduction to the use of Gradement's grade and scores to help the user in their investment decision making process. In other, more specific guides, you can find a more formal description of each of the scores calculated by Gradement (you can access them either from the Guides menu or from the score table, clicking on the score name you want to consult).
The easiest and quickest way to decide whether to invest or maintain an investment in a particular company is to simply check the value of its Grade. As with all other scores, the Grade:
- is a value that varies between 0 and 100
- the higher the value, the better the company from an investor point of view
The Grade is a summary of the rest of the main scores calculated by Gradement. In its simple value, from 0 to 100, are summarized ten years of accounting magnitudes, prices and financial statements and adjusted for the inflation of the currency in which the company's annual accounts are expressed.
Gradement uses the value of this score to grade each company into five categories:
and into this 13 subcategories
By limiting your investing to B and A companies, you will be sure to be investing in excellent companies from the accounting, economic and financial perspective. Following this strategy, you may also decide to sell when the company grade becomes a C, D or F company.
Companies with high grade
You will notice that very few companies, from the 25,000+ analyzed by Gradement, are getting today a B or higher. This is mainly due to the conservative way in which Gradement calculates all its scores. This Grade value is calculated using a combination of some other scores. Only when the rest of those scores had high value will this Grade also has a high value. A low value in any of those scores, although the vast majority of other company scores had a high value, will make a low-value Grade.
With this conservative calculation of the Grade, by requiring a high value in every other score, we will be excluding, as possible investments, excellent companies with great potential for growth and appreciation that happens to have a low value in some particular score. In return we have the assurance that all companies with a B or A had excellent grades in all the other major categories of which the Grade is composed. This way, although not all the excellent companies from the investor point of view get a B or A, we will have the assurance that all the companies that do obtain this B or A are indeed excellent companies from the financial, economic and accounting point of view (to put it otherwise, they are not all that they are, but they are all that are).
Another reason why, nowadays, only a small percentage of companies are rated by Gradement with a B or A is because of the current level of the stock markets price overvaluation worldwide. One of the main components of the Grade is the Price fairness score. This Price fairness score will have a high value only when the company is undervalued in the stock market. With prices so high today, there is little undervaluation in the stock quotations and, because of that, the Price fairness score presents a very low value in most of the companies.
PRICE, SOLVENCY AND PROFITABILITY
We have already seen the Price fairness score. It captures the level of undervaluation or overvaluation of the stock price of a given company. A low value is an indication of overvaluation (expensive shares) and a high value is indicateve of undervaluation (cheap shares). The other two main scores for which the Grade is composed are the Solvency score and the Profitability score.
The Grade includes in its calculation some other concepts but the main ones are these three: price, solvency and profitability. Those are, in our opinion, the three main axes with which to analyze every company.
Informally we can define profitability as the ability of the company to generate profits for shareholders. A company will be better the more profitable it is. But it is not enough just to look at profitability when investing. Profitability has to be qualified by two other important factors: solvency and price.
Solvency measures the ability of the company to meet its debts in a timely maner, and therefore, its ability to continue operating in the market. A low value of the Solvency score is an indication that the company has, or is expected to have in the future, difficulties in dealing with the payment of debts with third parties and so be subject to a possible bankruptcy and the corresponding liquidation/closure.
These three fundamental axes of all investment decisions, solvency price and profitability, are the ones that Gradement captures in a single value with the Grade.
Another reason why very few companies are classified as B or A is because of the existent reverse relationship between solvency, price and profitability. It's not easy to find companies that simultaneously have a high value in all this three categories because:
- Profitable and solvent companies are the most demanded by investors, this increases their price on the stock markets. Because of this tendency to overvaluation of profitable and solvent companies, the Price fairness score for this companies tend to have a low value.
- The financial profitability of a company can easily be increased (issuing debt with an interest rate lower than the economic profitability) but at the cost of decreasing its solvency. And vice versa, the solvency of a company can be increased but at the cost of diminishing its profitability. This inverse relationship between solvency and profitability means that, in general, few companies present high values in both scores simultaneously.
Although the Grade and its three main components: profitability, solvency and price, constitute, as we have seen, the three fundamental axes in every investment, there are another series of scores that analyze other very important aspects of the company and that, depending on the investment style or circumstances of the user, may give to them more or less weight in his investment decision making.
We give here a very brief introduction to the meaning and use of these other scores. Remember that in the rest of the guides you can find a more detailed explanation of each one.
All these scores, like all Gradement's scores, have a value ranging from 0 to 100, with 0 being the worst score possible and 100 being the best one.
The value of this score is an indication of the size of the company. Since there exists many ways to measure the size of a company this score uses a combination of them, but prioritizing some with respect to others. You can consider that the company is small if the score is less than 50. Large companies will be those with a score of 80 or higher.
Some investors have a preference for investing in small companies because of their potential for revaluation, while others prefer large companies because of their greater stability and security in general. These investors can use this score to filter, using the screener, those companies that they would want to analyze.
The score can also be used to get an idea of the relative difference in size between two companies that you want to compare.
This score measures the so-called country risk of the Government/State of the country in which the company had its headquarters. This country risk includes many factors: political risk, exchange rate and interest rates risk of the country's currency, economic risk (evolution of the country's economy), fiscal risk (taxes borne by the company and risk of State default), among others.
Since this score is not included in the calculation of the Grade, there may be companies with a high Grade value but with a low value in the geographic score. In this case the company is very good from the investor point of view but is located in a country with certain political/economic risks that can cause the Grade to deteriorate in the future.
You can see this score as an indication of the likelihood that the Grade (and the other scores) will remain at the current level in the near future. The greater the value of the score, the greater the future stability, and therefore, the greater confidence will have to be given to the rest of scores calculated by Gradement.
EXTERNAL FINANCIAL NON-DEPENDENCY
This score measures the level of the company's indebtedness in relation to the total value of its assets that it has. The lower the value of this score, the higher the level of indebtedness (lower financial independence of the company). It is not necessarily bad for the company to present a high level of indebtedness as long as it does not affect its solvency (the company may decide, for example, to increase its level of indebtedness to increase the financial profitability of its shareholders).
There are two versions of this score, one that includes as business debt the so-called commercial liabilities, and other that does not include them (you can consult here a detailed explanation of the concept of commercial liability).
This score measures the growth experienced by the company in the last seven years. There are many ways to measure growth. Gradement uses as proxy the variation of net income and free cash flow, albeit with a special emphasis on income and giving more weight to the most recent accounting periods.
Gradement automatically takes inflation into account in all its calculations (internally it uses constant monetary values). This way, we does not take into account the possible effects of an inflation increasease in the variables of income and cash flows when calculating the growth score.
This score measures the existing entry barriers in the company's industry. By barriers to entry we mean the difficulty that any company outside a given industry would have in grabbing market share from incumbent companies.
As a proxy for the entry barriers to a given industry Gradement uses the stability of the market share of the largest companies in that industry during the last accounting periods.
This score will have a value above 70 for companies that pay a high dividend level. For the calculation of the score, the dividend interest is compared with a proxy of the natural interest rate calculated by Gradement.
The Grade does not include in its calculation the dividend level to appraise the value of a company, because there are more appropriate variables for that (such as the free cash flow). However, this score is calculated because many investors consider important to analyze whether a particular company pays or not dividends, as well as the dividend interest rate offered.
This score is a measure of the level of capital expenditure (maintenance/renovation of machinery, buildings, etc.) that the company needs to continue operating and with the same level of activity. A low score value will be an indication that the company requires large capital expenditures (a capital intensive company) and a high value will indicate that it requires a low level of capital expenditure. All things been equal, a company with lower capital requirements will be better than another one with greater capital expenditure.
The level of capital expenditure mainly depends on the industry to which the company belongs.
For the calculation of the score, the capital expenditure is compared to the level of assets of the company (Capital needs asset-based score) and with the company's income (Capital needs revenue-based score).
This set of scores analyze the level of variation experienced by the following accounting variables of the company:
- Free cash flow
- Free earnings
- Operating cash flow
A high value of these scores will indicate that the corresponding variable has not experienced large downward oscillations: either it has remained constant or has increased in value. The stediness of these values reinforces the predictive nature of the rest of the scores. Because, in order to analyze an investment, we must necessarily rely on past accounting, the more stable the accounting variables are, the more likely the company will behave as the Gradement's scores predict.