In a recent article about ETFs, I wrote about the Invesco S&P 500 Quality ETF (NYSEARCA:SPHQ), a passive index fund looking for stocks in the S&P 500 with sound fundamentals. Interestingly, not one of the 102 holdings was Amazon (NASDAQ:AMZN) stock.
That made me question whether Amazon is a “quality” stock.
A high-quality score requires a high return on equity, a low accruals ratio, and a low leverage ratio. The S&P 500 Quality Index includes the top 100 stocks for quality scores based on these fundamentals.
You would think that given Amazon’s tremendous free cash flow — it generated more than $32 billion in 2023 — it would be one of the 100. Alas, it’s not.
I’ll examine the three ratios to determine why it’s not part of SPHQ.
Amazon Stock’s Return On Equity
SPHQ’s summary prospectus says the return on equity is calculated “as the company’s trailing 12-month earnings per share divided by the company’s latest book value per share.”
According to Morningstar.com, Amazon’s trailing 12-month earnings per share was $2.81. The Wall Street Journal says its current book value per share is $19.44, which means it has a return on equity of 14.5%. That’s good, but not great.
Nvidia (NASDAQ:NVDA), which is SPHQ’s largest holding with a 7.96% weighting, has a return on equity of 68.4% based on TTM EPS of $11.93 and a book value per share of $17.44.
While it’s easy to see why Nvidia is the top holding, it’s important to remind investors that when a company repurchases its stock, it reduces the equity on its balance sheet while increasing the earnings per share because of fewer shares outstanding.
This led to an artificially higher return on equity figures. Dividends also contribute to this phenomenon, although not nearly as much.
Because of Nvidia’s AI push, its earnings are absurdly high right now. I’m sure its return on equity will fall at some point.
The Accruals Ratio and Amazon Stock
The summary prospectus says the accruals ratio “is computed using the change of the company’s net operating assets over the last year divided by the company’s average total assets over the last two years.”
Net operating assets are the total assets minus the nonoperating assets such as cash and cash equivalents and marketable securities.
Using Amazon’s 2023 balance sheet from its 10-K, the change in the net operating assets from 2022 to 2023 is $48.43 billion, while the average total assets for the two years is $495.26 billion. That is an accruals ratio of 9.8%.
Using Nvidia’s 2024 balance sheet from its 10-K, the change in the net operating assets from 2022 to 2023 is $11.85 billion, while the average total assets for the two years is $53.46 billion. That is an accruals ratio of 22.2%.
At least from the accruals ratio perspective, Amazon’s earnings quality looks better than Nvidia’s.
Not Too Much Financial Leverage
The summary prospect, us says “Financial leverage is calculated as the company’s latest total debt divided by the company’s book value.”
Amazon’s 2023 total debt was $161.57 billion — defined as short-term borrowings, current portion of long-term debt, long-term debt, current portion of leases, and long-term leases — divided by its book value of $201.88 billion, good for a financial leverage ratio of 80.0%.
Nvidia’s 2024 total debt was $11.06 billion divided by its book value of $42.98 billion, which is good for a financial leverage ratio of 25.7%, considerably lower than Amazon’s.
The Bottom Line on Amazon Stock
Based on the three quality factors used by SPHQ, Nvidia does much better in two of the three metrics, suggesting it is a better-quality stock than Amazon.
However, keep in mind that these are only three metrics out of hundreds that investors can use to evaluate a company and its stock. Ultimately, a company’s business strategy is just as important, perhaps more so, than any single number.
I remain bullish about both stocks despite the quality differential.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.