Key metrics

Quality factors rely on metrics computed from the balance sheet and income statement that indicate profitability reflected in high profit or cash flow margins, operating efficiency, financial strength, and competitiveness more broadly because it implies the ability to sustain a profitability position over time.

Hence, quality has been measured using gross profitability (which has been recently added to the Fama—French factor model, see Chapter 7Linear Models), return on invested capital, low earnings volatility, or a combination of various profitability, earnings quality, and leverage metrics, with some options listed in the following table.

Earnings management is mainly exercised by manipulating accruals. Hence, the size of accruals is often used as a proxy for earnings quality: higher total accruals relative to assets make low earnings quality more likely. However, this is not unambiguous as accruals can reflect earnings manipulation just as well as accounting estimates of future business growth:

Factor

Description

Asset turnover

This factor measures how efficiently a company uses its assets, which require capital, to produce revenue and is calculated by dividing sales by total assets; higher turnover is better.

Asset turnover 12 month change

This factor measures a change in management's efficiency in using assets to produce revenue over the last year. Stocks with the highest level of efficiency improvements are typically expected to outperform.

Current Ratio

The current ratio is a liquidity metric that measures a company's ability to pay short-term obligations. It compares a company's current assets to its current liabilities, and a higher current ratio is better from a quality perspective.

Interest coverage

This factor measures how easily a company will be able to pay interest on its debt. It is calculated by dividing a company's EBIT (Earnings before interest and taxes) by its interest expense. A higher ratio is desirable.

Leverage

A firm with significantly more debt than equity is considered to be highly leveraged. The debt-to-equity ratio is typically inversely related to prospects, with lower leverage being better.

Payout ratio

The amount of earnings paid out in dividends to shareholders. Stocks with higher payout ratios were allocated to the top decile while those with lower payout ratios to the bottom decile.

Return on equity (ROE)

Ranks stocks based on their historical return on equity and allocates those with the highest ROE to the top decile.

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