Valuation ratios answer one question: is the stock cheap or expensive? Quality answers a different one: is the business behind it any good? A cheap stock of a weak company can stay cheap for ever; a good company bought at a reasonable price gives time a chance to work. This guide explains the five measures most used to judge quality, and what each one can hide.
What "quality" means
There is no official definition, but most investors mean the same things by it:
- The business earns a lot on what it uses.
- It does not depend on debt to survive.
- Its profits are stable, not a sequence of good and terrible years.
- It keeps a healthy margin between what it sells and what it costs.
Each of the following measures looks at one of these points.
1. ROE: how much it earns on the shareholders' money
Return on equity (ROE) compares the net profit with the shareholders' equity, the money the owners have in the company according to the accounts:
ROE = net profit / shareholders' equity
Hypothetical example: a company with 1,000 million of equity that earns 150 million in a year has an ROE of 15%.
A high and sustained ROE usually indicates a business with some advantage: a brand, a network, a cost structure that competitors cannot easily copy.
Its traps:
- Debt inflates it. A company that finances itself with loans has less equity, so the same profit gives a higher ROE. A high ROE with a lot of debt is a different story from a high ROE without it.
- Buybacks can break it. A company that has bought back many shares can end up with very small or even negative equity while being very profitable. Its ROE then becomes enormous or meaningless.
- One year can deceive. An extraordinary gain can inflate the profit, and therefore the ROE, for a single year.
2. Debt to equity: how much of the company is borrowed
The debt-to-equity ratio (D/E) compares what the company owes with what belongs to its shareholders:
D/E = total debt / shareholders' equity
A D/E of 0.5 means the company owes half of its equity; a D/E of 2, twice its equity.
Debt is not bad in itself: it can finance growth at a reasonable cost. The problem appears when the business has a bad year and the debt is still there, with its interest and its maturity dates. The more debt, the less room for error.
Its traps:
- It depends on the sector. Banks and insurers work with very high leverage by nature, and utilities or property companies carry more debt than a software company. Compare like with like.
- The same buybacks that distort the ROE also distort it: with very small or negative equity, the D/E stops meaning much.
3. Margins: how much of each sale stays in the company
Margins measure how much of every unit sold remains after paying different costs:
- Gross margin = (sales - cost of what is sold) / sales. It shows the pricing power of the product.
- Operating margin = operating profit / sales. It also counts salaries, rent, marketing and research.
- Net margin = net profit / sales. It includes interest and taxes.
Hypothetical example: a company sells 100, the product costs it 60 and its other operating costs are 25. Its gross margin is 40% and its operating margin 15%.
High and stable margins usually mean that customers are willing to pay for what the company offers. Falling margins year after year often mean competition is catching up.
Its trap: margins vary enormously between sectors. A supermarket lives with very thin margins and a software company with very wide ones; neither figure is good or bad without comparing it with similar companies.
4. Gross profitability (GP/A): profit over everything the company uses
Gross profitability (GP/A) divides the gross profit by the total assets of the company:
GP/A = gross profit / total assets
It is less known than ROE but has two advantages. It uses the gross profit, which is high in the income statement and harder to distort with accounting decisions, and it divides by all the assets, so it does not depend on how the company is financed. A company cannot improve its GP/A simply by taking on debt or buying back shares.
Academic research has studied it widely as a measure of quality for exactly that reason: it is a cleaner way of asking how much the business produces with what it has.
5. Earnings stability: profits you can count on
Two companies can have the same average profit over ten years: one earns roughly the same every year, the other alternates record years with losses. The first is much easier to value and much less likely to surprise badly.
Earnings stability measures that regularity. It does not say whether profits are high, only whether they are predictable. It is worth looking at together with the other measures: stable profits with a good ROE and little debt are a very different case from stable but tiny profits.
Read them together, never one alone
Each measure has a blind spot that another one covers:
A company that looks good on all of them is a different case from one that shines on only one.
Quality at InbestPlanners
The quality ranking orders the companies we cover by a quality score that combines four of these measures: gross profitability (GP/A), ROE, debt to equity and earnings stability. When a clearly profitable company has negative equity because of its buybacks, the score does not treat it as if it had a weak balance sheet.
The 360 Analysis of each company shows those four factors and, next to them, the value, dividend and technical sides. Quality describes the business, not the moment: neither of our signal methods uses it to decide an entry. To judge the price you pay for that quality, see P/E, Free Cash Flow and Book Value; to judge its dividend, Dividends and the Ex-Dividend Date. The full description is on the methodology page.
In short
- Quality is about the business: profitability, debt, margins and regularity.
- ROE is useful but debt and buybacks can inflate or break it.
- Debt to equity measures the room for error; compare it within the same sector.
- Margins show pricing power; GP/A measures gross profit without depending on financing.
- Stable earnings say how much you can rely on the profits, not how big they are.
This content is for educational purposes only and does not constitute financial advice. Past performance does not guarantee future results.