How I Evaluate Stocks

Summary

• Explains many of the factors I use to evaluate stocks.
• Gives a general outline of the Stock Evaluator, an evaluation system I plan to offer to subscribers.
• Backtests the Stock Evaluator on various groups of stocks.

I have long believed that the only way to make money picking stocks is to evaluate each stock on a large number of different criteria. My method has been successful so far, allowing me to make a return of 131% on my investments over the last 29 months (for a CAGR of 41%).

A few weeks ago, I introduced to my followers an “Ideal Stock Evaluation System,” which I hope to offer to subscribers on Seeking Alpha’s marketplace soon. I’m calling it the Stock Evaluator. Subscribers will get a weekly list of over 4,000 stocks, each ranked on a scale of 0 to 100, along with its price, sector, market cap, liquidity, yield, and other information.

In this article and subsequent ones, I want to clarify on what basis I evaluate and rank stocks, suggest some possible uses for the Evaluator, and provide some backtests. Just to be clear: unlike some evaluation systems and all stock screeners, I’m not giving stocks points based on whether they pass certain tests, but instead I’m using a more flexible weighted ranking system that rewards stocks that rank highly on certain metrics compared to others in the same industry, sector, or market.

Here are the top twenty factors that go into the Evaluator, with a word of explanation about each.

1. Projected earnings growth. This is a combination of four measures: the percent change between the current quarter’s earnings estimate and the same quarter last year; the percent change between this fiscal year’s earnings estimate and that of the most recent fiscal year; the company’s profit margin (with lower numbers better); and the company’s return on assets (with lower numbers better). These last two measures appear counterintuitive, but note that I’m not ranking based on weak earnings but on the potential for strong earnings, which can lead to earnings surprises and upward price movement. See my article on this here.
2. Sales growth, acceleration, and stability. I use some complex formulae to look for companies whose sales don’t jump around a lot from quarter to quarter, whose year-to-year sales growth is above average but not unsustainably high, but whose recent sales growth is accelerating. Like the previous factor, this is a combination of four different measures, each of which works well on its own.
3. Price to sales. This metric, especially when looked at in combination with other value ratios, has long been invaluable for comparing companies in the same industry; Jim O’Shaughnessy discussed it well in What Works on Wall Street. I look at both actual sales and projected sales (analyst estimates).
4. Dividend yield, dividend growth, earnings yield, and payout ratio. Using several formulae I compare the indicated annual dividend to the dividend paid last year; calculate the dividend yield and the earnings yield; examine five-year dividend growth; and look at the payout ratio (dividends paid to net income). Companies that pay no dividends get ranked right in the middle between companies with good dividend practices and those with bad (for example, those whose dividend payments exceed their income).
5. Low net operating assets. I look at the ratio of net operating assets to total assets. See my article on this measure here.
6. Low accruals. I look at the two basic measures of accruals: cash flow accruals, which is the ratio of net income minus operating cash flow to total assets; and balance sheet accruals, which is the change in net operating assets divided by average total assets. I look not only at the last year, but at the last three years too.
7. The ratio of R&D expenses to market cap, with higher numbers better. This is a very unusual metric that surprised me when I learned about it. I use it only for stocks in certain sectors; my testing has confirmed that it’s a terrific value ratio for those stocks. Indeed, a paper published in The Journal of Finance back in 2002 found that “companies with high R&D to equity market value (which tend to have poor past returns) earn large excess returns.”
8. Gross profit to enterprise value. My backtests have shown that this is another terrific measure of value. I look mostly at the last three years, but weight it more heavily on the last year.
9. Low share turnover. The ratio of share volume to float is a great measure of volatility. A recent study has demonstrated a very good correlation between beta and share turnover. I plan to devote a future article to this measure.
10. Price to tangible book value. This is an especially valuable measure for companies in the financial sector, but it can profitably be applied to other companies as well.
11. Operating margin stability. Companies that are growing their income but shrinking their sales are companies to avoid. Companies that are growing their sales but shrinking their income are also companies to avoid. I favor companies whose sales growth and operating income growth are in sync. See my article on this measure here.
12. Low short interest. I compare this to other companies in the same industry. Especially in the world of small caps, strong short interest can be a real sign of trouble ahead.
13. Accounting stability. I look primarily at the difference between last year’s cash conversion cycle and this year’s—that difference should be minimal. But I also look at the ratio of the change in accounts receivables to sales. Companies with unstable accounting can be unsafe investments.
14. Low price volatility. Technically, this should be called price variability, but everyone calls it volatility these days. (Properly speaking, volatility is beta.) This is simply the standard deviation of daily price returns.
15. Unlevered free cash flow to enterprise value. The basis for discounted cash flow valuation, this is an extremely important but often overlooked ratio; my research indicates that it works a lot better than the more common EV/EBITDA. Once again I look at both three-year and one-year figures.
16. Industry momentum. I favor stocks in industries whose average price has increased over the past year. The calculation I use here eliminates outliers and ADRs.
17. Free cash flow return on assets. Divide free cash flow by total assets. I like this ratio better than return on capital, return on equity, or other return measures, simply because my backtests show that free cash flow can be a better indicator of a company’s potential than net or operating income. For this measure, though, I use a somewhat unconventional measure of free cash flow: the sum of cash from operations and cash from investments (which is usually a negative number). In other words, I take acquisitions, divestitures, and other investing income into account here, not just capital expenditures. See my article on this here.
18. Gross margin to industry average. If you want to get a bead on whether a company has a strong “moat,” this is a great place to start. The companies with the highest gross margins, compared to the industry average, are the safest from competitors.
19. EVA yield. This is the ratio of economic value added, a measure invented by Joel Stern, to market cap. (I have to tip my cap to Joel Stern, who also came up with the concept of free cash flow.) Although EVA can be an extremely complex calculation, I’ve put in the hours to come up with a workable formula. EVA is a terrific indicator of a company’s health, and comparing it to market cap makes it a great value ratio.
20. PEG and PEG-like ratios. I lump here various measures that compare earnings growth and free cash flow growth to market cap to come up with measures that emphasize both low price and high growth.

Other things I look at include sustainable growth (ROE times retention rate), recent earnings growth, price momentum, gross plant to capital expenditures (the higher the better), asset turnover, basic sentiment indicators like earnings estimate revisions and recent earnings surprises, late statements (which are bad), share reduction (buybacks, which are good), employee growth, free cash flow margin, earnings stability, forward earnings yield (p/e), operating margin, return on capital, EV to EBITDA, EV to long-term debt, and EV to sales. I may add additional factors as new research supports change, or vary these somewhat; but I will be implementing changes only incrementally so as not to throw rankings off from week to week.

To conclude, below are a few decile backtests I’ve done on my ranking system using Portfolio123. These show the annualized returns of ten equal portfolios based on stock ranks, with a quarterly rebalance and no slippage, for six different groups of stocks. I have not optimized my system for these groups—in fact, I use exactly the same rules to rank a microcap as a large cap, and only a few of my rules are particular to sectors. (Please note: I did not include REITs in these backtests because I will be offering a different ranking system for those.)

In my next post, I’ll illustrate how investors with very different inclinations can profitably use the Stock Evaluator, and provide some backtested results.

Analyst’s Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.