Equities: Data Definitions: Snapshot: Stock Grades

 Stock Grades

The Morningstar stock-grading system consists of three grades, one in each of the following categories: Growth, Profitability, and Financial Health. They’re meant to be a quick way to get a handle on a company’s fundamentals.

All grades are based on relative rankings of companies within their sector. We use the 10 Morningstar sectors. For example, a company in the financial sector that receives an "A" in growth is a company that ranks near the top of the financial sector in terms of growth. We use sector comparisons to make sure we’re comparing apples to apples.

The grades are based solely on the numbers reported by the company in its SEC filings. Due to accounting conventions, however, these grades may or may not reflect the underlying economic reality, and investors should view the grades as a starting point for analysis rather than a definitive judgement on the company. No Morningstar analyst makes a subjective call as to what grade a company should get.

Distribution of grades
: Within each sector for each of the three categories (growth, profitability, and financial health), we give equal numbers of companies As, Bs, Cs, and Ds, while the bottom 10% get Fs.

Note that there’s no grade inflation. A grade of "C" means a company ranks right around the middle of its sector. It’s therefore very tough to get straight "As."

All information used to calculate the grades comes from Morningstar’s internal equities database.

 

 Growth Grade

The growth grade for all qualified companies in Morningstar's stock universe is based on valuation of revenue per share using data from the past five years. Companies with less than four years of consecutive revenue per share figures including the revenue per share figure for the latest fiscal year are tossed from calculations and are assigned “--“ for the growth grade. For the remaining qualified universe of stocks, the growth grade is based on the valuation of the growth rate of fully diluted revenue per share. Stocks are sorted based on the z-score of their revenue per share growth rate, from the most negative z-score to the most positive z-score and grouped into 10%, 20%, 40%, 20%, 10% buckets with F, D, C, B,  and A grades respectively for growth.


Sales %

The annual percentage change in a company's sales. The calculation is a given year's sales minus the prior year's sales, divided by the prior year's sales. The resulting figure is then multiplied by 100.
If this figure is positive, the company’s sales are growing; if it’s negative, sales are declining. However, it’s best to look at the Sales % for each of the past several years in order to identify patterns.


Earnings/Share %

The annual percentage change in a company’s EPS. The calculation is a given year’s EPS minus the prior year’s EPS, divided by the prior year’s EPS. The resulting figure is then multiplied by 100.

If this figure is positive, the company’s earnings are growing; if it’s negative, earnings are generally declining. However, it’s best to look at the EPS % Change for each of the past several years. Sometimes a one-time charge can depress earnings for a single year, even though the company’s earnings are generally rising; in other cases, earnings may have only started slipping in the most recent year.


Book Value/Share %

The annual percentage change in a company’s book value. The calculation is a given year’s book value minus the prior year’s book value, divided by the prior year’s book value. The resulting figure is then multiplied by 100. Book value is also called shareholders' equity, net worth, or total equity.

If this figure is positive, the company’s book value is growing; if it’s negative, book value is declining. However, it’s best to look at the book value/share % for each of the past several years in order to identify patterns.


Dividend/Share %

The annual percentage change in a company’s dividends. The calculation is a given year’s dividends minus the prior year’s dividends, divided by the prior year’s dividends. The resulting figure is then multiplied by 100. Increasing dividends are usually a signal that management has confidence in the company’s continued earnings power. Dividend growth—especially growth that has been steady from year to year—is a good sign for those investing for income.

 

 Profitability Grade

Profitability grade for all qualified companies in Morningstar's universe is based on valuation of return on shareholders' equity (ROE) using data from the past five years. Companies with less than four years of consecutive ROE figures including the ROE figure for the latest fiscal year are tossed from calculations and are assigned “--“ for the profitability grade. The remaining qualified stocks are first filtered for certain special situations and pre-assigned grades A, D and Fs.  Profitability grade for the remaining balance of this qualified universe is based on the valuation of the following three components, which are assigned different weights:

Stocks are sorted based on the average z-score of the above components and grouped into 25%, 50% and 25% buckets with B, C and more D grades respectively for profitability.


Return on Assets %

The percentage a company earns on its assets in a given year. The calculation is net income divided by end-of-year total assets . The resulting figure is then multiplied by 100. ROA shows how much profit a company generates on its asset base. The better the company, the more profit it generates as a percentage of its assets.


Industry Rank

Morningstar calculates the return on assets of the industry in which a company operates and assigns a percentile rank to the company depending on how it compares with the industry average. A percentile rank of 10 means the company ranks in the top 10% of companies in its industry in terms of return on assets.


Return on Equity %

The percentage a company earns on its total equity in a given year. The calculation is net income divided by end-of-year net worth. The resulting figure is multiplied by 100. Return on equity shows how much profit a company generates on the money shareholders have invested in the company. The mission of any company is to earn a high return on equity.


Industry Rank

Morningstar calculates the average return on equity of the industry in which a company operates, and assigns a percentile rank to the company depending on how it compares with the industry average. Companies are ranked on a scale of 1 to 100, with 1 representing those companies with the highest ROEs and 100 those with the lowest.


Net Margin %

This figure is a measure of profitability. It is equal to annual net income divided by revenues from the same period for the past five fiscal years and TTM. The resulting figure is then multiplied by 100.

This figure is a useful snapshot of how profitable a company was in a given year, but it should always be looked at in the context of net margin figures for previous years and for the trailing twelve months.

Net margin is one of the three ratios used in the calculation of return on equity (ROE), which is a measure of a company’s profitability. Asset turnover (sales/assets) and financial leverage (assets/equity) are the other two. Multiplying the three ratios together produces ROE, and raising any one of the three ratios will increase ROE.

Net margin and asset turnover are measures of how efficient a company’s operations are, while financial leverage is a measure of how much debt the company carries.


Asset Turnover

This figure represents how many dollars in revenue a company has generated per each dollar of assets. It is calculated by dividing total revenues for the period by total assets for the same period. Asset turnover can give an indication of how efficient a company is. A high asset turnover, which expresses how many times a company sells—or turns over—its assets in a year is a sign of high efficiency.

Asset turnover is one of the three ratios used in the calculation of return on equity (ROE, which is a measure of a company’s profitability. Net margin (earnings/revenues) and financial leverage (assets/equity) are the other two. Multiplying the three ratios together produces ROE, and raising any one of the three ratios will increase ROE.

Net margin and asset turnover are measures of how efficient a company’s operations are, while financial leverage is a measure of how much debt the company carries.


Financial Leverage

Financial leverage is defined as total assets divided by total shareholders’ equity. The higher the ratio, the more debt a company uses in its capital structure. Financial leverage is one of the three ratios used in the calculation of return on equity (ROE), which is a measure of a company’s profitability. Net margin (earnings/revenues), and asset turnover (revenues/assets) are the other two. Multiplying the three ratios together produces ROE, and raising any one of the three ratios will increase ROE.

 

 Financial Health Grade

The financial health grade consists of two components, which are weighted to arrive at an overall financial health grade.


Long-Term Debt $Mil

The dollar value of a company's long-term debt and other liabilities. Other liabilities can be any items not already included in current liabilities or long-term debt. Examples would include minority interest, capital leases, preferred stock of a subsidiary, and deferred taxes.
Long-term debt is one of the two main sources of long-term capital for a company, the other being shareholders’ equity. The mix of long-term debt and equity shows what capital structure a company’s management has chosen. Some firms prefer to rely solely on equity for long-term funds; others prefer to load up on debt in order to “leverage” their profits. By taking on debt, management can increase returns to shareholders (the return on equity), but only at the price of increased risk. If a company can’t pay back its long-term debt when it matures, bankruptcy ensues.


Total Equity $Mil

Total equity is also called shareholders' equity, net worth, or book value. Total equity, as with other balance-sheet items, is shown in millions of dollars ($M) and is current as of the fiscal year-end.

Total equity is one of the two main sources of long-term capital for a company, the other being long-term debt. Because total equity is the difference between a company’s total assets and its total liabilities, it represents (very roughly) the break-up value of the company. If a company were to sell off its assets and use them to pay off all of its liabilities, total equity would be about what it would end up with.


Debt/Equity

This ratio equals long-term debt divided by total shareholders' equity and is useful in determining how risky a company is. In comparison, debt/equity is also shown for the S&P 500.


Financial Leverage

Financial leverage is defined as total assets divided by total shareholders’ equity. The higher the ratio, the more debt a company uses in its capital structure. In comparison, financial leverage is also shown for the S&P 500.  


Current Ratio

This number equals current assets divided by current liabilities. This ratio measures a company's liquidity or its ability to meet its short-term obligations. In comparison, current ratio is also shown for the S&P 500.