Professional investors rarely start with valuation. They start by asking whether a business is good, because a great business bought at a fair price usually beats an average business bought cheaply. Five ratios get you most of the way to an answer.
Quality shows up as durable margins, high returns on the money invested in the business, profits that turn into cash, a balance sheet that is not stretched, and a share count that is not quietly growing. Look at each over five years, not one.
What to look at
- Gross margin: high and stable suggests pricing power. Compare with direct competitors, not the whole market.
- Operating margin: rising over time shows operating leverage as the company scales.
- ROIC (return on invested capital): above roughly 15% for years usually signals a competitive advantage.
- FCF conversion = Free cash flow ÷ Net income. Near or above 100% means earnings are real cash.
- Diluted share count: falling means buybacks; rising more than 2–3% a year means owners are being diluted.
The shape of it
ROIC = After-tax operating profit ÷ (Debt + Equity − Cash)
An example
Company A earns a 30% ROIC and grows 8% a year. Company B earns 6% and grows 20%. B's growth may destroy value if its returns are below its cost of capital; A can reinvest every dollar profitably.
Where people go wrong
One great year proves little. Margins peak in good economies and in cyclical industries. Always look at a full cycle before calling a business high quality.
This is a screen, not a verdict. A company that fails it might be fixing itself; one that passes might be about to be disrupted. But it tells you quickly where to spend your research hours.