Here we are going to look at how to go about assessing the operational quality of a stock or is it a good business which can generate returns for shareholders. Since we have used current profitability, cash flow and dividends in the value scoring I like to focus here on longer term measures to get a feel for stability and sustainability in these metrics.
I use five year average operating margin and five year average return on capital employed (ROCE) as indicators of the quality of a business. See the highlighted links for further discussions on these from Investopedia which is itself a useful resource for education and more about investing, albeit US centric.
Thus a Company with high and stable margins and returns will score more highly than one that sees lower figures on these measures that are volatile. For example a pharmaceutical stock would likely score well on this, as you might expect, given their high research & development spend which provides patent protected products. Whereas a house builder which might be earning good margins and ROCE today probably wasn't a few years ago, so this will have a lower score despite the current profitability to reflect the variability of it profits.
Using longer term averages therefore helps to identify, to an extent, those that have high and stable returns over those with lower and more volatile returns or cyclical companies - which should in any event be fairly obvious based on what they do. However, if we get into another extended economic cycle then some cyclical companies may appear to have high and stable margins and returns so you would then need to interpret this score with a bit of care and use your common sense.
In addition it will penalise those stocks that have seen margins and returns decline, so again you would need to do more research to see the reasons behind this, whether they are at cyclical low or if they are on a recovering trend or even moving into new areas under new management, which might lead to higher returns and can be a good thing for a value / recovery situation.