Education Series | July 25, 2017
Representing companies comparative earning growth and earning quality through unique scores for easy reference and further analysis.
A company`s earning growth is an important parameter to compute company valuation whether we follow absolute valuation method like discounted cash flow or relative valuation method like P/E ratio, EV/Ebdita etc. Corporate earning performance is one of the most common yet important independent variables for judging a stock.
To measure earning performance, various measures such as sales growth, PAT (profit after tax) growth and EPS (earning per share) growth are employed. These parameters are calculated for various periods such as last 5 years, 3 years or just the previous year (called quarter - on quarter or Q-o-Q). However, stock picking is not just about looking at one company’s performance for one particular period. It requires comparison of earning performance of stock vis-a-vis its peers in the industry and all other stocks in the market.
This can be done by measuring the earning performance of all companies in the market using the same set of variables. Earning score is one such measure and it has two dimensions - Earning Momentum which computes growth rate of earning and Earning Quality which measures the quality of the company’s earning.
Calculating Earning score
Earning score calculation consists of calculating earning momentum & earning quality.
Method for calculating earning momentum
Earning momentum calculation requires calculating earning’s velocity, acceleration, and consistency. Earning velocity is a weighted average of the rate of growth in operating profit calculated for previous eight quarters. While calculating earning velocity of a company, first of all, its trailing 12 months operating profit (Pre Provisioning Profits in the case of banks) is calculated at the end of each of the previous eight quarters. (Thus it takes into account quarterly profit for last 12 quarters). Thereafter, the change in trailing 12 months operating profit for last 8 quarters is calculated and different weights are assigned to it. The highest weight is assigned to the rate of change for the latest quarter. From thereon, weights are reduced going towards previous quarters. Finally, earning velocity of the recent quarter is calculated which is a weighted average of the rate of growth for eight recent quarters.
Similarly, earning velocity of the quarter prior to the recent quarter is also calculated.
These earning velocities of two recent quarters are used to calculate the earning acceleration of the latest quarter. Earning Acceleration of the latest quarter is the percentage change in earning velocity of the latest quarter over the earning velocity of the prior quarter.
Earning Consistency is the process of reducing the earning velocity of stocks by the weighted growth of those quarters where earning growth had been negative.
Next, stocks are ranked based on each of the earning characteristics i.e., velocity, acceleration and consistency. Ranks of each stock are then summed up to obtain a value called earning momentum value. This earning momentum value is now used to assign a new rank and percentile value to each stock, called earning momentum score.
So, earning momentum score is a relative term: Higher earnings momentum score for a company signifies that its earning is growing at a speed higher than other stocks in the market and vice-versa.
Method for calculating Earning Quality
In order to calculate earning quality- operating profit margin (OPM), net profit margin (NPM), debtor’s turnover ratio (DTO), and Interest Coverage Ratio are used. For Financial sector Companies, %NNPA, NIM% are used.
Thereafter, the median value of above mentioned financial parameters is calculated for every industry. Then, the divergence of each stock’s quality variable from its industry median value is calculated.
Stocks are then ranked on each of the quality variables separately based on the divergence observed. Therefore, there are three different sets of ranking. This ranking is positive for OPM & NPM and stocks are penalized for DTO.
Now, a combined rank for each stock based on all these three quality variables is derived; which is then converted into a percentile based score. These percentile based scores are termed as quality score.
Once earning momentum, quality score and earning score of a stock is calculated, by averaging these two scores by equal weights.
Features and advantages of Earning Score
1) Earning score is number specific to a company
2) A company can have earning score in the range of 0 to 99.99 depending upon its earning performance vis-à-vis other stocks in the market.
3) Companies with lower earning score have lower earning growth than the ones with higher score.
4) Earning score of a stock reflects the percentage of stocks whose earnings are growing at a pace slower than the pace of the stock into consideration.
5) Earning score readily helps in assessing whether company’s earnings are growing at higher speed combined with better quality.
6) Change in earning score helps in identifying the companies whose quarterly earnings have improved or deteriorated. lt also helps in making communication easier between various market participants while talking about company’s fundamental performance.
7) A company’s earning score along with other fundamental variables such as valuation and price score creates a basis for picking stocks from the market. Clubbing earning score of stocks in a sector or an industry helps in knowing earning score of overall industry or sector.
8) Many times an analyst identifies a company on the basis of possible business turn around and uses rising earning score as a trigger for timing a buy.
9) The return of stocks of various earning scores during any time period (such as intraday, daily weekly or monthly) helps in predicting the future market trend.
10) Rules based on earning score help in creating a quantitative portfolio.