Screening for Value Using the Fundamental Rule of Thumb

    by John Bajkowski

    Investors deal with a number of trade-offs in their security selection and analysis. Seeking out stocks that offer high levels of current income entails giving up some growth potential. This basic trade-off is illustrated clearly by the Fundamental Rule of Thumb screen, which combines earnings yield, dividend yield, and the ratio of earnings retained to book value. All of these elements are well known and frequently used by value investors. When combined, a score is computed that can help indicate if a stock merits further analysis.

    The rationale for a screen that combines earnings yield, earnings retention, and dividend yield is simple: Every value investor should seek growth and dividends at a bargain price. Of course, growth and dividends in one company are often contradictory, and therefore trade-offs are necessary. Exceptional growth can offset a low or non-existent 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.

    A screen that follows the Fundamental Rule of Thumb approach is built into Stock Investor Pro, AAII’s fundamental stock screening program and research database. The screening criteria used in the program are detailed at the end of the article.

    Figure 1.
    Fundamental Rule
    of Thumb
    Screen Performance

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