I will be publishing my Q2 2022 earnings wrap-up in a few days. Every quarter, I score the stocks that I own and several more that are on my watchlist. I compare these stocks' performance over multiple quarters along two dimensions:
business performance
stock price action
This exercise helps me identify the stronger companies where I might want to put my money to work.
Before the Q2 report comes out, I believe it is time to update my readership on how I evaluate and score stocks. Since I published my Q1 report in early June, we have had a 42% increase in readership on this substack. So it is important to level set everyone on my method.
Why do I score stocks?
Because it allows me to sift through dozens of potential candidates to short list the ones that have the best potential to perform well in 2022-2023. It helps me put a numerical score to each of the key metrics that I believe demonstrate:
current business health
future business potential
I also use this quantitative method to quickly compare two stocks in the same industry. This year, especially, I want to ensure that my money is in the strongest stocks that are performing well amidst all the market volatility.
Consistently, each quarter, I find that the higher-scoring stocks perform better than the lower scoring stocks.
Returns from the top cohort are about 24% better than the lower cohort.
Yes, you read that right.
The top scoring stocks have lost about 31.5% since the start of 2022
The lowest scoring stocks have lost 55.9% over that same timeframe
…using prices as of the time of this writing on Sept 20th.
Metrics used in the scoring algorithm
Revenue growth YoY
Revenue growth FWD YoY
Revenue growth QoQ for last 3 quarters + est. next quarter
RPO (Remaining performance obligations) increase for last 4 quarters
Gross margin
Gross margin expansion over the last 4 quarters
EBITDA margin expansion over the last 4 quarters
Operating cash flow margin expansion over the last 4 quarters
Free cash flow margin expansion over the last 4 quarters
Customer growth for last 4 quarters (preferred large customers)
Net retention rate expansion for the last 4 quarters
Cash on balance sheet
Total debt/cash on balance sheet
Institutional ownership expansion over the last 4 quarters
Is a tailwind helping the business?
Is the company buying back shares?
Does the company have a market dominant position?
Is the company entering new markets or releasing new products?
Are there external factors putting pressure on the business?
Has the original thesis changed?
Stock price is not factored in
I do not include any stock price related metric in the scoring. I want to evaluate these companies based solely on their past business performance and future business prospects. I track a few valuation metrics on the side which help me with buy and sell decisions:
Morningstar fair market value
Enterprise value/Gross profit
(Enterprise value/Gross profit)/FWD growth rate
Other items of note
The RPO metric above gives a small advantage to stocks that sell their services on a subscription basis. This is by design because their business model creates a contractual 2-5 year revenue pipeline…that’s a good thing.
Net retention rate also provides an advantage to companies that track and report this metric. I will take into consideration any measurement that reports how much a company is cross-selling or upselling to existing customers.
I give a higher weight and, in some cases, extra credit to a few metrics that I consider more important than others such as:
Revenue growth FWD YoY
Gross margin and gross margin expansion
Customer growth (especially large customers)
Cash on hand
Market dominance among peers and competition
Bottomline
I am a numbers guy at heart. I keep my methods simple and grounded in facts - actual, reported business data that is in the earnings reports of these companies.
I do not conduct any sort of fancy analysis, extrapolations or forecasting. That would just end up with guesses that might not come to fruition.
These scores, fall as they may each quarter, give me confidence that I am not missing any important factor. I can then make a clear cut, investing decision on each stock.