Check Out This Grading System for Comparing Stocks (+2K Views)

So conveys Dr. Osman Gulseven in his original article which Lorimer Wilson, editor of www.munKNEE.com (It’s all about Money!), has further edited ([  ]), abridged (…) and reformatted below  for the sake of clarity and brevity to ensure a fast and easy read. Please note that this paragraph must be included in any article re-posting to avoid copyright infringement.

Gulseven goes on to say:

The 3 Components

Let’s explain this further:

1. First thing we need is the current dividend yield. The higher, the better.
2. Second, we need to estimate the earnings growth. The higher, the better.
3. 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.

The Formula

Here is the simple, yet powerful, formula, used by Wall Street investors: O-Metrix = (Dividend Yield + EPS Growth) / (P/E Ratio) X 5

The Application

Applying the O-Metrix Grading System to stocks listed in Dow Jones Industrial Index gives us the following results:

(Data is from finviz, and is current as of August 29, 2011)

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.

The Results

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.

The Limitations

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.

The Conclusion

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.

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