Let’s go over five of my favorite stock metrics to quickly analyze the quality of a business, having spent years looking at companies as a hedge fund analyst, both at a glance and in a deep dive.
Revenue growth (__%):
A quality company’s fundamental goal is to grow profitably and sustainably. Thus we should start by looking at how quickly they are increasing sales.
I generally consider any company expected to grow over 10% per year into the future as a growth company. Companies that are more mature or in a less dynamic industry tend to grow at 2-10% per year depending on individual momentum. And even for the most mature companies, I still would prefer to see at least inflationary revenue growth of around 2%.
Gross profit margin (__%):
This metric shows how much direct profit the company makes per unit of product it sells.
I look for both high and stable gross margins. The higher the gross margin is, the more profit the company makes every time it sells something, which often implies a higher quality business model.
Differentiated software products often carry over 70% gross margins, while grocery stores only have 20% to 30% gross margins. I also look to see if gross margins have varied historically. We want to see stable and increasing growth margin trends, which implies product pricing defensibility.
EBITDA margin (_ %):
For most businesses, EBITDA is a great quick way to estimate a company’s “cash profit.”
EBITDA is calculated as Net Income + Taxes + Interest Expense + Depreciation & Amortization. EBITDA margin is when you divide EBITDA by Revenue, comparing what percentage of revenues turn into cash profits.
EBITDA margin shows how profitable the business actually is. Gross margins can look high with many different types of companies. Still, if a business requires physical locations or hefty corporate expenses, it will have a lower EBITDA margin than a software company that just has a small tech team on staff.
If the company is in hyper-growth mode, I focus on EBITDA much less, as these companies are spending as much as possible on pure growth. But if the company isn’t throwing everything at growth, we definitely want to see EBITDA profitability or at least a path to profitability.
While I’m here, I also look at how much the company spends on sales and marketing expenses and compare that to its revenue growth. It makes sense that a company spends a lot here to drive growth forward, but if a company has massive sales and marketing expenses but unimpressive growth, it can suggest high churn or that these costs are required just to keep the business stable.
Cash conversion ratio (__%):
This metric shows us how much of its profits a business actually turns into cash flow. In reality, we care about how much cash a company generates, not what its accounting “Earnings” are. I personally like calculating this as (Cash From Operations – Capital Expenditures) / EBITDA.
The higher the cash conversion ratio, the company is more straightforward and is better at generating cash. Suppose a company has a low or negative cash conversion ratio. In that case, it can suggest the business has inadequate working capital or capital expenditure dynamics and requires ongoing investments that aren’t shown on the Income Statement.
Interest coverage ratio (__x):
This metric shows us if the company has a healthy or unhealthy amount of debt.
I like calculating this as (EBITDA – Capital Expenditures) / Interest Expense. If the metric is 2.0x, it means the company generates enough cash per year to cover its debt interest expenses two times over. If this metric is close to or under 1.0x, it implies that the company can’t cover its debt obligations and has an unhealthy amount of debt.