Derek Chipman's  Instablog

Despite the anticipated bull-market rally from January to March, many market participants seem to wonder if a correction is on the way. The Dow Jones industrial average (DJI) is suppose to be a benchmark reflecting the performance of the market as a whole, however it has yielded a high return over the last month. January's strong US auto sales reported by General Motors (GM) and Ford (F) in combination with optimism surrounding the outlook for US jobs, sent the Dow soaring last Friday. On Friday, it was the first time since October 2007, the Dow broke 14,000. After witnessing this increase, I cannot say I disagree with anyone who thinks a short-term market correction is on the way. But regardless, the question surrounding fair value will continue to exist. Does the fundamental performance of each underlying security within the Dow, support its current price?

For many, the price of the Dow is merely a number. A number that is a more accurate measure of how a trader feels about the economy, than an investor with a long-tem focus. Since January 1st, the Dow has yielded nearly 6.91%, and has a current price to earnings ratio of roughly 13.71x. Since 2009, the Dow's average return on equity has increased to 30.5% from 25.5%. But in terms of both gross and profit margins, we have yet to see a full recovery. This article provides a broad overview of the fundamental performance of the all thirty securities underlying the Dow through a scoring methodology that uses Poitroski's Fundamental Score.

The fundamental scoring model used in this article is a slight variation of Poitroski's traditional model. For those who are unfamiliar with this model, it is simply a combination of nine different accounting checks used to derive a final score reflecting the quality of a specific firm. The final score is a discrete number ranging from zero to nine that focuses on a firm's financial position through concentrating on three key areas. These three key areas include profitability; leverage, liquidity, and source of funds; and operating efficiency. The maximum points that can be achieved from each category is four, three, and two respectively. Each firm receives a point for every constraint it satisfies below.

Profitability

1. Positive net income in the current year
2. Positive operating cash flow in the current year
3. Return on assets must be increasing and greater than the previous year
4. Operating cash flow must be greater than return on assets and net income

Leverage, Liquidity, and Source of Funds

1. Lower level of long-term debt in the current year relative to the value of total assets in the previous year
2. The current ratio must be greater than the previous year
3. There must be no additional equity issued in the previous year

Operating Efficiency (maximum, 2 points)

1. Gross margin must be progressively increasing and higher than it was in the previous year
2. Asset turnover must be increasing as well and higher than it was in the previous year

The Fundamental Scoring Model

The output shown below illustrates the fundamental score of each company in the Dow as well as the firms score for every category. Notice the firms have been ranked in alphabetical order and not by they fundamental score they received. The output of this model revealed a decent variation in the results. Not a single firm received a score of nine. The top two firms, Cisco Systems (CSCO) and Home Depot (HD), both received a score of eight. Next in line was Walt Disney (DIS), AT&T (T), and The Travelers Companies (TRV), which all received a score of seven. The remaining twenty-five companies in the Dow received a score less than or equal to six. The stand-alone arithmetic average score of the overall index is 4.6, which is extremely low. If you take a close look at the figure below, you will notice the variation between a pass and fail score is easily distinguished by the green and pink highlighting, respectively.

Among the three categories, profitability appears to be the Dow's strongest fundamental attribute. With the exception of Hewlett- Packard (HP), every firm within the Dow displays positive operating cash flow. The parameters evaluating the quality of these firms earnings revealed great results, which is expected given positive signs of strong operating cash flow across the board. In regards to profitability, the primary concern is return on assets. From year over year, more than half of the firms in the index have failed to improve their return on assets.

(click to enlarge)

As indicated by the cells highlighted in pink, the key issues concerning these firms within the index are primarily concentrated around the right portion of the chart. This area includes operating efficiency, liquidity, and leverage. All of these factors have major implications on a long-term growth. A firm's sustaintable growth rate is indirectly a function of its leverage and operating efficiency. And the ability for a firm to sustain long-term growth can be heavily influenced by poor performance in these areas.

In regards to leverage, the issue lies at the heart of a firms capital structure. This model does not take into account the specific value of a firm's weighted average cost of capital, however it contrasts its long-term debt with its assets from the previous period. This provides an understanding as to how leveraged a single firm is in terms of its financing through debt. As you will see above, this model reveals that majority of these firms are using a substantial amount of debt financing. In terms of liquidity, this model suggests roughly half of the firms in the Dow are experiencing lower levels of liquidity now as opposed to the previous year. Majority of the firm's current ratios declined over the past year. Five of the firms that improved their current ratio from the previous year engaged in the issuance of new equity. Using equity issuances for sources of funds was most likely utilized for paying off portions of long-term debt as well as finishing up existing projects. The last category this model focuses on is operating efficiency. Unfortunately, this area does not reveal the most promising results. The only three firms to pass both constraints under this category are HD, T, and Walmart (WMT). All three firms not only increased gross profit margins from the previous year, but also have displayed a progressive increase in its turnover on fixed assets.

Conclusion

Considering the definition of accuracy, all models are wrong. The value added from a model is not if its 100% right or wrong, but rather how its utilized. The value added solely derives from the utility you receive from it. In practice, as long as the underlying assumptions and data used in the model are credible and precise, the model therefore has a useful purpose. The model used in this analysis takes into account these firm's most recent financial data and was constructed with the intent of providing a big picture view of the financial condition for each firm in the Dow. Overall, the firms within the Dow are exhibiting strong levels of profitability, however there is a lot of uncertainty surrounding capital structure and operating efficiency. In the short-term, I feel a small-correction as a result of traders selling off positions to retain profits is highly plausible. However, my main concerns still reside underlying long-term growth prospects because lowered levels of liquidity and declines in operating efficiency will only suppress long-term growth.

Sources: TD Ameritrade, Bloomberg, Google Finance, and The Wall Street Journal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.