Monday, December 11, 2006

Standard & Poor's Ranking System

When I mention a specific stock in one of my posts, I often cite the company's S&P Earnings and Dividend Quality Ranking. The reason I cite the ranking is the analysis that encompasses a specific grade. Following are a few key factors that go into determining a company's grade. As Standard & Poor's states:

  • Standard & Poor’s has provided Earnings and Dividend Rankings, also known as Quality Rankings, on common stocks since 1956. These Quality Rankings capture Graham and Dodd’s definition of sustainable earnings power, are used in portfolio management as prudent investments, and are commonly employed in investment litigation to determine the prudence of stock investments. A long history of Quality Rankings is available, and several academic and practitioner studies have examined their informativeness and reliability.
  • After analyzing the risk, return, and fundamental characteristics of Quality Rankings portfolios, S&P examines the relationship between Quality Rankings and several other measures of earnings quality. They show that earnings growth of higher-quality firms, as defined by Quality Rankings, is more predictable than that of lower-quality firms. They also show that companies with higher Quality Rankings appear less likely to engage in accounting manipulations. Companies with high Quality Rankings also have higher quality of earnings as defined by the Standard & Poor’s Core Earnings methodology. S&P's analysis shows that high quality stocks indeed have generally traded at higher multiples. The analysis of fundamentals, however, shows that the premium in multiples for the higher-quality portfolio is justified by better fundamentals. Thus, S&P's results show that higher-quality stocks command higher multiples and deliver higher returns. These results are different from the conventional wisdom established by previous studies on risk factors in the U.S. equity markets, and provide a new insight into the risk and return characteristics of U.S. stocks.
  • Finally, S&P report characteristics of current and historical Quality Rankings portfolios. Results show that high-quality stocks generally have greater liquidity, higher average price per share, and larger market value. In addition, Quality Rankings exhibit high stability over time. This implies that portfolio strategies based on Quality Rankings can be executed in practice.
  • The Quality Rankings System attempts to capture the growth and stability of earnings and dividends record in a single symbol. In assessing Quality Rankings, Standard & Poor’s recognizes that earnings and dividend performance is the end result of the interplay of various factors such as products and industry position, corporate resources and financial policy. Over the long run, the record of earnings and dividend performance has a considerable bearing on the relative quality of stocks. The rankings, however, do not profess to reflect all of the factors, tangible or intangible, that bear on stock quality.
  • The rankings are generated by a computerized system and are based on per-share earnings and dividend records of the most recent 10 years – a period long enough to measure significant secular growth, capture indications of basic change in trend as they develop, encompass the full peak-to-peak range of the business cycle, and include a bull and a bear market. Basic scores are computed for earnings and dividends, and then adjusted as indicated by a set of predetermined modifiers for change in the rate of growth, stability within long-term trend, and cyclicality. Adjusted scores for earnings and dividends are then combined to yield a final ranking.
  • The ranking system grants some exceptions to the pure quantitative ranking. Thus, if a company has not paid any dividend over the past 10 years, it is very unlikely that it will rank higher than A-. In addition, companies may receive a bonus score based on their sales volume. If a company omits a dividend on preferred stock, it will receive a rank of no better than C that year. If a company pays a dividend on the common stock, it is highly unlikely that the rank will be below B-, even if it has incurred losses. In addition, if a company files for bankruptcy, the model’s rank is automatically changed to D.


Standard & Poor's Quality Rankings
Massimo Santicchia and Philip G. Murphy, CFA
October, 2005

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