Fundamental Rule of Thumb Screen
|Fundamental Rule of Thumb||S&P 500|
|Five Year Return:||1.3%||14.1%|
|Ten Year Return:||6.3%||5.9%|
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 P/E ratios below the market average." Others combine elements such as the PEG ratio, which divides the P/E ratio by earnings growth and looks for values below one.
Many of the traditional value rules are based upon dividend yields and have become difficult to implement as investors have de-emphasized the importance of dividends and focused in on earnings growth potential. One old value screen still applicable in today's market 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 combined, a score is computed which can help indicate if a candidate merits further analysis.
In order to any use any screen effectively, the individual investor should understand the rationale for the screen, the components of the screen, how these components interact, and how to interpret and adjust the results when applied to specific 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 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.
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