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

In this article I cover a classic strategy that combines three fundamental factors into a score used to identify promising value stocks. The AAII Fundamental Rule of Thumb screen combines the price-earnings (P/E) ratio, dividend yield and adjusted return on equity (ROE). A list of stocks that currently pass the Fundamental Rule of Thumb screen is included below. This screening model has shown impressive long-term performance, with an average annual gain since 1998 of 9.6% through the close on February 28, 2023, versus 5.6% for the S&P 500 index over the same period. Read on to understand why this screen is still valid in today’s market.

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 1.0.

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 of these elements are well known and well used by value investors. When these ratios are combined, a high numerical total provides 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, having both high growth and a high dividend in one company is contradictory, making trade-offs 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 earnings-retained-to-book-value ratio 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 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 the annual earnings after 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 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 ratio of earnings less dividends to book value 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. This 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 the 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.

Stocks Passing the Fundamental Rule of Thumb Screen (Ranked by Relative Price Strength)

The three ratios are highly interrelated. RCM Technologies Inc. (RCMT) has an earnings yield of 14.2%, which translates into a low price-earnings ratio of 7.04 (1 ÷ 0.142). With a ratio of earnings retained to book value of 56.4% and a dividend yield of 0%, RCM Technologies has a fundamental rule of thumb score of 70.6%. RCM Technologies’ total liabilities as a percent of total assets equal 52.2%, below the industry median of 62.8% for the construction and engineering industry. Excess debt can boost the ratio of earnings retained to book value, but with increased risk. We therefore added a screen that requires a firm’s liabilities relative to assets level to be at or below its industry norm. While RCM Technologies’ stock price is up 102.8% over the last 52 weeks, it is down 4.4% 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 American depositary receipts (ADRs) of foreign stocks, closed-end funds and real estate investment trusts (REITs). To assure basic liquidity, we also exclude over-the-counter (OTC) bulletin board stocks.

Regardless of how you use the Fundamental Rule of Thumb 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.