Fundamental Rule Of Thumb Strategy Screen Still Valid In Today’s Market

In this article I cover the classic strategy that combines three fundamental factors into a score used to identify promising value stocks. The Fundamental Rule of Thumb screen combines the price-earnings (P/E) ratio, dividend yield and an adjusted return on equity.

A Basic Value Rule of Thumb for Screening Stocks

Precepts for the analysis of common stocks abound and new rules, old rules and new versions of old rules are constantly floating around the investment community. These rules usually sound deceptively simple, such as “look for price-earnings ratios below the market average.” Others combine elements such as the PEG ratio, which divides the price-earnings ratio by earnings growth and looks for values below one.

Many of the traditional value rules have become difficult to implement as investors are focused on earnings growth potential. One classic value screen still applicable today combines earnings yield, dividend yield, earnings retention levels and return on equity. All these elements are well known and well used by value investors. When these ratios are combined, a high numerical total becomes a score to sort out stock candidates for further analysis from the thousands of stock opportunities available to investors.

To use any filter effectively, the individual investor should understand the rationale for the score, the components of the score, how these components interact, and how to interpret and adjust the results when applied to individual stocks.

The rationale for a screen that combines earnings yield, earnings retention and dividend yield is simple: Every value investor should seek high growth and high dividends at a bargain price. Of course, high growth and high dividends in one company are contradictory, and therefore trade-offs are necessary. Exceptional growth can offset a low or nonexistent dividend yield and can be worthy of further analysis if the stock price is relatively low. On the other hand, a high dividend yield and a low price relative to earnings can compensate for lower growth.

The components of the fundamental rule of thumb score are earnings yield, the ratio of earnings retained to book value, and dividend yield.

Earnings Yield

Earnings yield is simply earnings per share divided by share price:

Earnings Yield = EPS ÷ Price

Where:

• EPS = Earnings per share for the most recent 12 months
• Price = Market price per share of the common stock

The earnings yield relates the generation of earnings to the stock price. A high earnings yield is desirable. Earnings per share and price are also the components of the price-earnings ratio, which is simply price per share divided by earnings per share; it is the reciprocal of the earnings yield.

A relatively high earnings yield is equivalent to a relatively low price-earnings ratio. Numerically, for example, if the earnings yield for a stock is 8.0%, its price-earnings ratio would be 12.5 (1 ÷ 0.08)—in other words, the price is 12.5 times earnings per share. The lower the earnings yield, the higher the equivalent price-earnings ratio. Using estimated future earnings and assuming growth in earnings—rather than using earnings for the most recent 12 months (termed trailing earnings)—should result in a higher earnings yield and a lower price-earnings ratio.

The earnings yield takes on significance and meaning when compared to a benchmark, such as other firms within the same industry, the overall market level, or even the bond yield. Investors such as Warren Buffett compute the earnings yield because it presents a rate of return that can be compared quickly to other investments. Buffett goes as far as to view stocks as bonds with variable yields, and their yields equate to the firm’s underlying earnings. The analysis is completely dependent upon the predictability and stability of the earnings. Buffett likes to compare a company’s earnings yield to the long-term government bond yield. An earnings yield near the government bond yield is considered attractive. The bond interest is cash-in-hand but it is fixed, while the earnings of a company should grow over time and push the stock price up.

Earnings-Retained-to-Book-Value Ratio

The second component is the ratio of earnings retained to book value. Earnings retained are simply annual earnings after the annual dividends to preferred and common shareholders have been paid. They are reinvested by the firm and determine the growth in book value.

Book value consists of all of the assets of the firm, less all debt and other obligations. When divided by the number of outstanding common shares, the figure becomes book value per share. The “book” in book value is an accounting determination rather than a market valuation. Book value is often termed shareholder’s equity or net worth.

Retained Earnings to Book Value = (EPS – DPS) ÷ BVPS

Where:

• EPS = Earnings per share
• DPS = Dividends per share
• BVPS = Book value per share

The ratio of earnings retained to book value measures change or growth in book value, but it is better thought of as an adjusted return on equity. The more commonly used return on equity figure is the ratio of earnings per share to book value.

The earnings less dividends to book value ratio is the most intricate and difficult to interpret of the three fundamental value ratios, primarily because of the book value figure. Excessive debt or financial leverage, either absolutely or relative to industry averages, can produce a low book value figure relative to total assets. That means that, while the ratio of earnings retained to book value may be high, the firm is accomplishing this growth with above-average risk.

The second complication in the evaluation of this ratio is relevance of book value. As an accounting measure, book value came about in an attempt to measure the net value of physical assets that can be used to create future cash flows and earnings. Book value does a better job of examining traditional industrial firms, but for service- or technology-oriented firms, future earnings potential is more likely a function of the value of intangible assets and human capital employed by a company. If you are examining a firm that has significant and valuable intangible assets not captured on the balance sheet, the ratio of earnings retained to book value is probably overstated.

Dividend Yield

The third fundamental value ratio is the dividend yield, which relates the annual cash dividend on the common stock to the current market price of the common stock.

Dividend Yield = DPS ÷ Price

Where:

• DPS = Indicated dividend per share
• Price = Market price per share of the common stock

While this screen is seeking high dividend yields, it is important to remember the trade-off between the dividend yield and future growth rate. The more dividends that are paid, the higher the dividend yield but the lower the ratio of earnings retained to book value.

Screening for Stocks With High Fundamental Scores

Our primary screen totals the three ratios and requires a minimum total value for further analysis. A total value of 25% is a suggested minimum. We took our current list of exchanged-traded companies with the highest fundamental rule of thumb and present here the 20 stocks that have the strongest weighted relative price strength. Our screening model has shown impressive long-term performance, with an average annual gain since 1998 of 11.5%, versus 6.4% for the S&P 500 index over the same period.

Today’s Fundamental Rule of Thumb Stock Ideas

The three ratios are highly interrelated. Fulgent Genetics (FLGT) has an earnings yield of 19.1%, which translates into in very low price-earnings ratio of 5.23 (1 ÷ 0.191). With a ratio of earnings retained to book value of 55.1% and a dividend yield of 0%, Fulgent Genetics has a fundamental rule of thumb score of 74.2%. Fulgent Genetics’ total liabilities as a percent of total assets equal 13.9%, below the industry median of 52.9% for the health care facilities & services industry. Excess debt can boost the ratio of earnings retained to book value, but with increased risk. We therefore added a screen that requires that a firm’s liabilities relative to assets level be at or below their industry norm. While the stock price of Fulgent Genetics is up 132% over the last 52 weeks, it is only up around 13% over the last quarter.

The interpretation of book value can require some additional scrutiny, but the screen can serve as a useful rule of thumb as long as the individual investor is aware of the circumstances that may cause exceptions.

Since the screen allows comparison of all types of firms, from growth companies to mature dividend payers, it is touted as a universal initial screen for comparison among all firms. As such, it is a useful cross-industry screen, particularly suited for combing through many stock candidates. However, we have added a few criteria to exclude ADRs of foreign stocks, closed-end funds and real-estate investment trusts (REITs). To assure basic liquidity, we also exclude over-the-counter bulletin board stocks.

Regardless of how you use the screen, it is essential to follow it up with an analysis that delves into the financial history of the firm, including factors such as earnings stability, financial structure, new and old products, competitive factors and the prospects for future earnings growth.

____

The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.