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While stocks might look risky in the short-term, they offer the highest yield in the long-run, says Prof. Jeremy Siegel, from the University of Pennsylvania, Wharton School of Business. In his book "Stocks for the Long-Run," Siegel suggests that the stocks offer more stable real returns than bonds in the long run, thanks to the mean reversion effect. His book also offers several actionable techniques that investors might find beneficial. One of the interesting metrics suggested by Prof. Siegel uses simply three essential parameters:

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.

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) * 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

Caterpillar

CAT

11.68

2.16%

21.00%

9.91

A-Grade

General Electric

GE

10.85

3.86%

13.76%

8.12

A-Grade

Hewlett-Packard

HPQ

5.46

1.93%

8.04%

9.13

A-Grade

Intel

INTC

8.61

4.25%

10.69%

8.68

A-Grade

JPMorgan Chase

JPM

7.11

2.76%

9.39%

8.54

A-Grade

Walt Disney

DIS

12.42

1.23%

14.27%

6.24

B-Grade

3M

MMM

12.63

2.75%

12.86%

6.18

B-Grade

Microsoft

MSFT

8.71

2.53%

11.25%

7.91

B-Grade

Travelers

TRV

8.75

3.40%

8.64%

6.88

B-Grade

United Tech.

UTX

12.73

2.68%

12.67%

6.03

B-Grade

Exxon Mobil

XOM

8.82

2.59%

8.22%

6.13

B-Grade

American Express

AXP

12.17

1.49%

10.38%

4.88

C-Grade

Boeing

BA

12.66

2.68%

11.66%

5.66

C-Grade

Cisco

CSCO

10.66

1.57%

10.65%

5.73

C-Grade

Chevron

CVX

7.89

3.22%

5.90%

5.78

C-Grade

EI DuPont

DD

11.45

3.56%

9.20%

5.57

C-Grade

Home Depot

HD

13.89

2.94%

13.18%

5.80

C-Grade

IBM

IBM

12.61

1.77%

10.83%

5.00

C-Grade

Coca-Cola

KO

14.37

2.74%

8.93%

4.06

C-Grade

P & G

PG

14.75

3.36%

9.14%

4.24

C-Grade

AT&T

T

10.12

5.92%

5.89%

5.84

C-Grade

Verizon

VZ

14.83

5.45%

8.48%

4.70

C-Grade

Wal-Mart

WMT

11.39

2.76%

9.36%

5.32

C-Grade

Johnson & J.

JNJ

13.78

3.55%

6.09%

3.50

D-Grade

Kraft Foods

KFT

16.47

3.42%

9.32%

3.87

D-Grade

McDonald's

MCD

16.88

2.71%

10.35%

3.87

D-Grade

Merck & Co.

MRK

15.71

4.76%

4.81%

3.05

D-Grade

Pfizer

PFE

12.51

4.39%

3.28%

3.07

D-Grade

Alcoa

AA

11.12

1.01%

3.00%

1.80

F-Grade

Bank of America

BAC

N/A

0.52%

12.33%

N/A

N/A

Average

11.76

2.93%

9.79%

5.71

C-Grade

*Data is from finviz, and is current as of August 29.

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 average P/E ratio of DJI stocks is 11.76. Average dividend yield is 2.93% and average annualized EPS growth estimate is 9.79%. Based on the EPS growth estimates the stocks in Dow Jones index have an average O-Metrix score of 5.71. Bank of America is the only stock that I could not calculate its O-Metrix score, since it has not reported any profits yet.

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.

Source: Top Dow Jones Stocks For The Next 5 Years