AAII Stock Ideas: Fundamental Rule of Thumb Strategy Screen

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 of 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

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

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

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 15 stocks that have the strongest weighted relative price strength.

Today’s Fundamental Rule of Thumb Stock Ideas

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

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American Association of Individual Investors

American Association of Individual Investors

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Since inception in 1978, the nonprofit AAII has helped over 2 million individuals build their investment wealth through programs of education and publications.