The profitability grade for all qualified companies in Morningstar's stock universe is based on valuation of return on shareholders' equity (ROE) using data from the past five years. Morningstar's universe of stocks is first filtered for adequacy of historical ROE figures. 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. For the remaining qualified universe of stocks the profitability grade is based on the valuation of the following three components, which are assigned different weights:
The historical growth rate of ROE,
The average level of historical ROE, and
The level of ROE in the latest fiscal year of the company.
After applying the profitability filters, for the remaining universe of qualified stocks and for all three components of the profitability grade, we calculate:
Z-score,
Weight z-score,
Rank weighted z-score, and
Map the ranked weighted z-score into profitability grades.
The filters that are applied to the qualified universe before calculating the z-scores is a key difference between the profitability growth grade calculations and the growth grade calculation. ROE raw data of the qualified universe of stocks are sequentially filtered three times and certain companies that are expunged and pre assigned F, D, and A profitability grades, respectively.
First filter: If the arithmetic historical average ROE is less than zero, the stock is pre assigned F for its profitability grade.
Second filter: If the ROE growth rate is negative and the latest fiscal year ROE level is less than 5%, the stock is pre assigned D for its profitability grade.
After the above two consecutive filters are applied, the remaining qualified stocks are filtered again for the third and last time. If the arithmetic historical average ROE is 25% or more, the ROE growth rate is positive, and the latest fiscal year ROE is greater than zero, stock will be pre assigned A for its profitability grade. The remaining stocks after this final filter are then graded based on their average z-score ranks.
4Historical growth rate of return on equity
A simple regression is performed on five-year historical ROE figures - a minimum of four (4) consecutive years of ROE figures including the latest fiscal year figure is required. In calculating this component of profitability the slope of the regression line will be divided by the arithmetic average of "absolute" value of historical ROEs - this is different than regression analysis applied to growth calculations and reflects the fact that ROEs can be negative. The result of the regression is a normalized annualized historical increase or decrease in the rate of growth for ROE.
4Z-Score and Profitability Grading
Because we already pre-graded the special situations based on the filters described previously for grades F, D, and A, we don�t need to worry about the A and F grades. There could, however, be more Ds in the universe. Therefore, we calculate the z-score for the qualified stocks that remain after the previously described three consecutive filters. The final weighted average z-score of the three components of profitability grade is calculated as follows;
Weighted Average Z-Score =
25% (Z-score calculated from the historical growth rate of ROE) - component 1
+ 50%( Z-score calculated from the average level of historical ROE) - component 2
+ 25% (Z-score calculated from the level of ROE in the latest fiscal year of the company) - component 3
Within remaining universe of qualified stocks is sorted based on the stocks' final weighted average z-score from negative to positive. Stocks are then ranked from 1 to total number of stocks based on their final weighted average z-score. Each stock rank is then divided by the total number of stocks to calculate the cumulative percentile rankings.
4Ranking and Mapping of Z-Scores for Profitability Grades
|
Qualified Stock Universe |
Cumulative Percentile |
Grade |
|
Filtered Universe |
NA |
F, D, and A |
|
Remaining Universe Percentile Rank � Low to High |
Cumulative Percentile |
Grade |
|
25% |
25% |
D |
|
50% |
75% |
C |
|
25% |
100% |
B |