Quality Score

In this article, we will discuss the methodology used in computing quality score.

Quality is yet another factor that has been shown to deliver positive risk premium. Quality is a phenomenon that stocks of safe, profitable, and growing companies tend to outperform the market.

Our quality score is inspired by methodology used in the paper Quality Minus Junk (Asness, Frazzini, and Pedersen (2013)).

Accordingly, quality can be broken up into 3 components:

• Profitability – Stocks with higher efficiency and margins
• Growth – Stocks with growing profitability
• Safety – Stocks with stable returns and healthy balance sheets.

For each of the 3 components, we calculate their composite score as described below.

For profitability score, we consider Return on Equity (ROE), Return on Assets (ROA), Cashflow Return on Assets (CFROA), Earnings quality score, Operating profit margin and Operating cashflow margin.

For growth, we consider change in profitability ratios in the last 3 years. We use 3-year change in ROE, ROA, CFROA, Operating profit margin and Operating cashflow margin. The change (delta) is calculated such that a positive number indicates growing profitability while a negative number indicates shrinking profitability.

For safety, we consider 3 metrics – Volatility of daily returns in the last 1 year, beta of the stock (w.r.t Nifty 50) in the last 1 year and debt to equity ratio.

Using our standard scoring methodology, we arrive at composite scores (between 0 and 100) for profitability, growth, and safety. These scores are then aggregated into a single quality score.