Jeremy Siegel offered in his book, Stocks for the Long-Run, several actionable techniques that investors might find beneficial, one of which was a 3 parameter approach to stock valuation called the O-Metrix Grading System. The metrix has been applied to all 30 stocks listed on the Dow Jones Industrial Index and 5 stocks top the list. Below is an explaination of the approach, the formula and the results for all 30 stocks. Words: 985
A rule of thumb for stock valuation that is found on Wall Street is to calculate the sum of the growth rate of a stock’s earnings plus its dividend yield and divide by its P-E ratio. The higher the ratio the better, and the famed money manager Peter Lynch recommends investors go for stocks with a ratio of two or higher, avoiding stocks with a ratio of one or less.
The 3 Components
Let’s explain this further:
- First thing we need is the current dividend yield. The higher, the better.
- Second, we need to estimate the earnings growth. The higher, the better.
- Third, we need the P/E ratios. Lower is better. Taking the average of trailing and forward P/E ratios will smooth the results. Thus, I will use the average P/E of trailing and forward P/E ratios.
Here is the simple, yet powerful, formula, used by Wall Street investors: O-Metrix = (Dividend Yield + EPS Growth) / (P/E Ratio) X 5
Applying the O-Metrix Grading System to stocks listed in Dow Jones Industrial Index gives us the following results:
|Company||Ticker||Avg. P/E||Yield||EPS Growth||O-Metrix Score*||Grade|
|P & G||PG||14.75||3.36%||9.14%||4.24||C-Grade|
|Johnson & J.||JNJ||13.78||3.55%||6.09%||3.50||D-Grade|
|Merck & Co.||MRK||15.71||4.76%||4.81%||3.05||D-Grade|
|Bank of America||BAC||N/A||0.52%||12.33%||N/A||N/A|
(Data is from finviz, and is current as of August 29, 2011)
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Besides the O-Metrix ranking system, I also introduced a letter grading system as such:
- 10+ : A+ Grade Stock
- 8 to 10: A Grade Stock
- 6 to 8: B Grade Stock
- 4 to 6: C Grade Stock
- 2 to 4: D Grade Stock
- 0 to 2: F Grade Stock
- <0 : Sub-F Grade Stock
The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far. Peter Lynch suggests 2 as a perfect number. Therefore, I multiplied the scores by 5 in order to rank the stocks on a 10-point scale. The formula above can be used to rank not only high dividend stocks, but low-dividend or growth stocks as well.
Caterpillar, a Jim Cramer favorite, has the highest O-Metrix score of 9.91, followed by General Electric (8.12). The results show that technology stocks are deeply undervalued and they have the potential to outperform the index in the next 5 years. Hewlett-Packard, Intel, and Microsoft have A-Grade O-Metrix scores of 9.13, 8.68, and 7.91. Cisco, the fallen star of the techno bubble show, has a C-Grade O-Metrix score of 5.73, followed by IBM that has an O-Metrix score of 5.
Note that the above formula is a simple valuation metrics. Although suggested by a prominent scholar as Wall Street’s rule-of-thumb, it ignores many other factors such as dividend growth rate, payout ratio, sustainability, profitability, etc. Yet it can be a powerful tool to add into your knowledge base.
Investors might want to consider stocks with higher than average O-Metrix scores for achieving superior returns in the long-term. After all, the formula offers a nifty balance of dividend yield and growth.
Benjamin Graham, the “godfather of value investing” created an equation to calculate the maximum fair value for a stock, referred to as the Graham Number and any stock trading at a significant discount to this number would appear undervalued. [Here are the names of 18 such stocks.] Words: 1707
Benjamin Graham, known as the father of value investment, is famous for his simple, yet powerful, valuation method as first explained in his 1973 book, Intelligent Investor, and later updated in his book entitled Renaissance of Value. His “Graham Number” approach has been adapted and applied to all 30 stocks listed on the Dow Jones Industrial Index to determine which of the stocks have above average safety factors – of which only 10 do. Below is an explaination of the approach, the formula and the results for all 30 stocks. Words: 1220
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