How to find Quality Companies? (Checklist)

Here is a useful checklist you can use when you are searching for quality companies:

1.   Company's sales record.

• You want to see high and growing sales, year after year.
• A ten-year period of increasing sales and profits is a good sign.

2.  Company's profits.

• You want to see high and growing profits, as measured by normalised EBIT, year after year.
• A ten-year period of increasing sales and profits is a good sign.

3. EBIT and normalised EBIT 

• Check that these are roughly the same in most of the last ten years.

4.  EBIT margin.  

• The EBIT margin must be of at least 10% almost every year for the last ten years.

5,  ROCE

• The company must have a ROCE that is consistently above 15% over the last ten years.
• ROCE = (EBIT / average capital employed ) x 100%

6.  DuPont analysis

• Carry out a DuPont analysis to find out what is driving a company's ROCE.
• ROCE = EBIT/Capital Employed = (EBIT/Sales) x (Sales/Capital Employed)
• ROCE = {Profit margin x Capital turnover)

7.  Annual report

• Read a company's annual report to provide context for the numbers.

8.  FCFF and FCF

• Look for a growing free cash flow to the firm (FCFF) and free cash flow for shareholders (FCF), over a period of ten years.
• FCFF and FCF should also be roughly the same in most years.
• That is, little debt.

9.  Operating cash conversion ratio 

• Look for companies that turn all of their operating profits (EBIT) into operating cash flow, as represented by an operating cash conversion ratio of 100% or higher.
• Operating cash conversion ratio = (operating cash flow / operating profit) x 100%
• That is, high quality earnings

10.  Capex ratio

• Look for capex ratio less than 30% almost every year over the last ten years.
• That is, low capex requirements.
• Capex ratio = Capex / Operating Cash Fow

11.  Compare Capex to its depreciation and amortisation expenses.

• If the company is spending more on capex than its depreciation and amortisation expenses, it is a sign that it is spending enough but you need to be sure it isn't spending too much.

12.  FCFF/Capital Employed or CROCI

• Check for free cash flow to firm return on capital invested that is higher than 10% almost every year over the last ten years.
• This is also known as cash-flow return on capital invested (CROCI)
• CROCI = adjusted free cash flow tot he firm (FCFF)/average capitl employed

13.  Compare FCFps to EPS

• Look for free cash flow per share to be close to earnings per share in most of the last ten years.
• That is, high quality earnings.

14.  Free cash flow dividend cover

• Free cash flow per share should be a larger number than dividend per share in most years.
• That is, the free cash flow dividend cover should be greater than 1.
• Free cash flow dividend cover = FCFps / DPS
• Occasional years when this is not the case are fine.

15.  Consistent Growth

• Prefer more consistent growth in turnover and profit to more volatile growth.

Comments:


Don't worry if you cannot find a company that meets ALL of the criteria above.

There are some exceptional companies that do.

Typically you will not find hundreds of them.

Companies can improve and the ones that might not have been good ten years ago can be good companies now.

If you can find companies that have a high and improving ROCE and have been good at converting profits into free cash flow over the last five years, you should consider them as well.