Monday , 2 August 2021

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

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:

CompanyTickerAvg. P/EYieldEPS Growth O-Metrix Score*Grade
General ElectricGE10.853.86%13.76%8.12A-Grade
JPMorgan ChaseJPM7.112.76%9.39%8.54A-Grade
Walt DisneyDIS12.421.23%14.27%6.24B-Grade
United Tech.UTX12.732.68%12.67%6.03B-Grade
Exxon MobilXOM8.822.59%8.22%6.13B-Grade
American ExpressAXP12.171.49%10.38%4.88C-Grade
EI DuPontDD11.453.56%9.20%5.57C-Grade
Home DepotHD13.892.94%13.18%5.80C-Grade
P & GPG14.753.36%9.14%4.24C-Grade
Johnson & J.JNJ13.783.55%6.09%3.50D-Grade
Kraft FoodsKFT16.473.42%9.32%3.87D-Grade
Merck & Co. MRK15.714.76%4.81%3.05D-Grade
Bank of AmericaBACN/A0.52%12.33%N/AN/A

(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.

Related Articles:

1. Which Stocks Trade at a Discount to the “Graham Number”?

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2. How the Dow 30 Stocks Compare According to Their Margins of Safety

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