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    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
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Evaluating the Screen

    The companies passing the screen, along with a simple hypothetical portfolio, have been reported and tracked on AAII.com for the last six and a half years (see Figure 1). The screen lagged the market in 1998 and 1999, a period in which the market favored growth strategies over value approaches. Its subsequent performance has been very strong on both an absolute and relative basis. The screen even managed to show a positive gain during 2002, a year in which most market segments experienced strong declines. Overall, the cumulative gain for the screen is 265.8% compared to a 14.9% gain for the S&P 500.

    Earnings Yield
    The primary components of the screen are earnings yield, earnings retained to book value, and dividend 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 (price per share divided by earnings per share); it is the reciprocal of the earnings yield.

    P/E Ratio = Price ÷ EPS
      = 1 ÷ (EPS ÷ Price)

    TABLE 1. Fundamental Rule of Thumb Portfolio Characteristics
    Portfolio Characteristics Fundamental
    Rule of
    Thumb
    Screen
    All
    Exchange-
    Listed
    Stocks
    Market cap (million) $203.70 $349.10
    Price-earnings ratio 5.3 19.5
    Price-to-book-value ratio 2.36 2.07
    EPS 5-yr. historical growth rate 26.00% 8.00%
    EPS 3-5 yr. estimated growth rate 46.70% 9.30%
    Total liab. to total assets 38.10% 52.60%
    Relative strength vs. S&P 14.00% 2.00%
    Monthly Observations
    Average no. of passing stocks 50  
    Highest no. of passing stocks 51
    Lowest no. of passing stocks 49
    Monthly turnover 77.00%

    In this form, it is apparent that 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 5%, its price-earnings ratio would be 20 (1 ÷ 0.05)—in other words, the price is 20 times earnings per share. The lower the earnings yield, the higher the equivalent price-earnings ratio.

    The market is forward-looking in its analysis. If it expects high future growth in earnings for a given stock with great certainty, it may be willing to accept a lower earnings yield (higher price-earnings ratio) today for that stock.

    The characteristics of the stocks passing the Fundamental Rule of Thumb screen are presented in Table 1, while Table 2 lists the top 25 companies currently passing the criteria, as ranked by their rule of thumb score.

    NRG Energy leads the pack with the highest earnings yield figure of 127.4%. This translates to a price-earnings ratio of 0.78 (1 ÷ 1.274)—an unusually low number that probably points to a data anomaly. As it turns out, NRG emerged from bankruptcy late last year and adjusted its books to reflect the fair market value of its assets and liabilities. This “fresh start” accounting adjustment boosted net income for the period prior to reorganization to $2.8 billion, resulting in trailing-12 month figures that are not representative of current or future operations. Conseco and Bay View Capital have also had recent financial statement adjustments from reorganizations. NAVTEQ Corporation and Cohen & Steers are examples of freshly listed stocks that underwent reorganizations and financial statement adjustments prior to their initial public offerings.

    Overall, the median price-earnings ratio of the Rule of Thumb stocks is over a quarter of the market level—5.3 vs. 19.5.

    Earnings and Value
    The second component of the Fundamental Rule of Thumb is the ratio of earnings retained to book value. Earnings retained are simply annual earnings after the annual dividends have been paid to preferred and common shareholders. Earnings retained 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 “equity,” “shareholder’s equity” or “net worth.”

    Ratio of Earn. Ret. to Book Val. =
    (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, or sustainable growth rate. The more commonly used return on equity figure is the ratio of earnings per share to book value. If no dividend is paid, return on equity equals earnings retained to book value. Carmike Cinemas passed the screen with a 50.1% ratio of earnings retained to book value. Carmike Cinemas earned $10.29 per share over the last four quarters, has an indicated annual dividend payout of $0.70 per share and a book value per share of $19.13. These figures lead to an extremely high 50.1% ratio [($10.29 – $0.70) ÷ $19.13], but a number of one-time actions led to these values. Carmike Cinemas emerged from Chapter 11 reorganization in 2003 with a low book value from many years of significant losses. In late 2003, it recorded a deferred tax asset valuation credit of $75.3 million resulting in a one-time earnings gain over the last four quarters and an inflated ratio of earnings retained to book value as well as an inflated earnings yield.

    The ratio of earnings less dividends to book value is the most intricate and difficult to interpret, primarily because of the book value figure and the many factors that can impact earnings.

    Screening Criteria
    • Exclude companies that trade on the over-the-counter (OTC) market
    • Exclude American depositary receipts (ADRs)
    • Exclude REITs and closed-end funds
    • The ratio of total liabilities to total assets ratio needs to be below the industry median
    • Only those companies with the 50 highest Fundamental Rule of Thumb scores are included in the final results
    The Fundamental Rule of Thumb score is calculated as:
    Earnings Yield 12m + Earnings Retained to Book + Dividend Yield

    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 seeks 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 less the company has in cash to build for future growth.

    Carmike Cinemas has a dividend yield of 2.0% based upon an indicated dividend of $0.70 per share ($0.70 ÷ $35.20). Carmike has just paid its second quarterly dividend after a long period of reorganization and a recent secondary stock offering. While most companies do not start paying a cash dividend unless they are confident of their ability to continue to do so in the future, a longer track record is a desirable feature.

    Fundamental Score

    The rule of thumb screen totals the three ratios and looks for companies with a high value. The three ratios are highly interrelated. A firm with an earnings yield of 5% that pays no dividend would need a ratio of earnings retained to book value of at least 20% to qualify with the desired score of 25%.

    The 50 companies with the highest Fundamental Rule of Thumb score are tracked and presented on AAII.com, however, only the top 25 are displayed in Table 2 due to space restrictions.

    As indicated in Table 2, Carmike passed the screen with an 81.4% Fundamental Rule of Thumb score. However, a one-time tax credit boosted Carmike’s score. Substituting the historical earnings per share figure with the I/B/E/S consensus expected earnings figure of $2.73 would result in a lower earnings yield (7.8% versus 29.2%), a lower ratio of earnings retained to book value (10.6% versus 50.1%), and an overall score of 20.4% versus 81.4%. A score of 20.4% is good, but below the desired 25% benchmark for the screen.

    The Fundamental Rule of Thumb screen has performed well, but it tends to turn up troubled and neglected small to mid-sized companies that require careful, in-depth analysis. All screens represent starting points in the stock selection process, but screens that highlight deep-discount stocks require extra diligence to build profitable portfolios. Many investors would be wise to steer clear of these stocks unless they are able to fully understand the accounting, legal and industry factors impacting these companies. Of course, it is this type of neglect that can lead to mispriced stocks and buying opportunities.

    TABLE 2. Fundamental Rule of Thumb Firms (Ranked by the Fundamental Rule of Thumb Score)
    Company (Exchange: Ticker) Earnings
    Yield
    (12 Mos)
    (%)
    Earnings
    Retained
    to Book
    Value
    (%)
    Div
    Yield
    (%)
    Fund’l
    Rule of
    Thumb
    Score
    (%)
    Total
    Liab to
    Total
    Assets
    (%)
    Mkt
    Cap
    ($ M)
    Description
    NRG Energy (N: NRG) 127.4 139.6 0 267 70.3 2,776 power genera’n facilities
    Conseco (N: CNO) 96.5 85.9 0 182.4 89.4 2,647 insurance holding co
    Bay View Capital Corp. (N: BVC) 82.2 64.8 0 147 64.1 110 financial services
    NAVTEQ Corp. (N: NVT) 6.5 107.8 0 114.3 38.8 3,375 digital map info
    Talk America Holdings (M: TALK) 49.2 58.3 0 107.5 50.8 141 telephone services
    MotorVac Tech (M: MVAC) 83.8 22.6 0 106.4 16.2 2 auto engine repair
    ADDvantage Tech (A: AEY) 9 83.3 0 92.3 26.6 45 cable TV equip repair
    Cohen & Steers (N: CNS) 6.5 81.7 2.4 90.6 50.5 579 real est mutual funds
    iMERGENT (A: IIG) 20.4 66.8 0 87.2 24 102 e-commerce tech
    Carmike Cinemas (M: CKEC) 29.2 50.1 2 81.4 62.4 428 movie theaters
    Insteel Industries (M: IIIN) 22.9 55.2 0 78.1 59.8 146 mfrs wire products
    Excel Maritime Carriers (A: EXM) 5.9 70.9 0 76.8 23.1 375 dry bulk shipping
    Hallwood Group Inc. (A: HWG) 24.2 52.4 0 76.6 46.3 123 real est, textile hold co
    United American Healthcare (M: UAHC) 21.2 54.1 0 75.3 25.9 37 healthcare servs
    Sand Technology Inc. (M: SNDT) 36.4 36.8 0 73.1 18.6 12 data-handling software
    Simulations Plus (A: SLP) 14.3 57 0 71.3 11.6 15 pharm simul’n software
    Janus Capital Group Inc. (N: JNS) 31.2 36.3 0.3 67.8 32.2 3,236 mutual fund mgmt co
    PHAZAR CORP. (M: ANTP) 14.6 47.3 0 61.9 29.8 13 hold co for antenna mfr
    PetroKazakhstan Inc. (N: PKZ) 12.9 45.1 1.2 59.2 37.3 3,012 oil & gas in Kazakhstan
    Yankee Candle Co. (N: YCC) 5.5 52.6 0 58.1 56.2 1,324 scented candles
    USANA Health Sciences (M: USNA) 3.8 53.9 0 57.7 31 630 nutrition & care prods
    Hungarian Telephone & Cable (A: HTC) 18.6 38.2 0 56.8 66.3 118 telephone services
    Competitive Technologies (A: CTT) 9.2 46.8 0 56 19.7 25 tech transf & license
    Louisiana-
    Pacific Corp. (N: LPX)
    19.5 34 1.1 54.6 50.7 3,022 home-building prods
    Novamerican Steel Inc. (M: TONS) 21.3 32.9 0 54.1 51.8 262 carbon & stainless steel


    John Bajkowski is AAII’s financial analysis vice president and editor of Computerized Investing.

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