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Stock Rating Methodology

Tuesday, November 22nd, 2011

New Con­structs’ stock picks are reg­u­larly fea­tured by Barron’s, CNBC, SumZero and other experts. Details here.

We assign one of five ratings to every stock under coverage: Most Attractive (best rating), Attractive, Neutral, Dangerous, Very Dangerous (worst rating). These same ratings apply to ETFs and mutual funds.

Ratings are based on the 5 most important criteria for assessing the risk versus reward of stocks. Those criteria are divided into two categories: “Business Strength” and “Valuation”. Our uniquely rigorous diligence in footnotes helps protect clients from stock blow-ups.

A)  Busi­ness Strength: the qual­ity of the eco­nomic earn­ings of the com­pany and the strength of its busi­ness model based on its ROIC.

1)     Qual­ity of Earn­ings mea­sures how reported account­ing income com­pares to the eco­nomic earn­ings of the company.

2)     Return on Invested Cap­i­tal (ROIC) mea­sures the aggre­gate cash on cash returns of the company.

B)  Val­u­a­tion: based on the expec­ta­tions embed­ded in stock prices. Investors should buy stocks with low expec­ta­tions.

3)     Free Cash Flow Yield mea­sures the true cash yield of  the company.

4)     Price to Eco­nomic Book Value mea­sures the growth expec­ta­tions embed­ded in the stock price.

5)     Market-Implied Dura­tion of Growth (Growth Appre­ci­a­tion Period) mea­sures the num­ber of years of future profit growth required to jus­tify the cur­rent val­u­a­tion of the stock.

Figure 1, the New Constructs’ stock rating table, shows how the criteria above translate into our rating for every stock, ETF, and mutual fund we cover.

Figure 1:  Stock Rating Table

Sources:   New Constructs, LLC

You will find Figure 1 in every one of our Stock Reports as well as many of our reports on ETFs and mutual funds. For more explanation behind the thresholds that drive the Predictive Rating, see Figure 4 at the end of this post.

To illustrate New Constructs’ stock ratings in action, below are the explanations behind how stocks make our monthly Most Attractive Stocks and Most Dangerous Stocks lists. For details on the performance of our Most Attractive and Most Dangerous Stocks since 2005, please see Proof Is In Performance.

Stocks make our Most Attractive list because they have:

  1. High-Quality Earnings based on:
    • Returns on Invested Capital that are rising; and
    • Economic Earnings/Cash Flows that are positive.

AND

  1. Cheap Valuations  based on:
    • Free-Cash Flow Yields[1]that are positive;
    • Price-to-Economic Book Value (EBV)[2] ratios that are relatively low; and
    • Growth Appreciation Periods[3] (GAP) that are relatively low.

The above characteristics also qualify stocks for a ‘Very Attractive’ or ‘Attractive’ Rating, according to our stock rating system. Figure 2 below shows our stock rating table, which we include in the reports for each of the 3000+ companies that we cover. Stocks get a grade of 1 to 5 for each criterion, 5 being the worst and 1 being the best score. The Overall score is based on the average score of all five criteria. Stocks must get an average score of 1.4 or below to be rated Very Attractive. For the most part, only Very Attractive stocks qualify for our Most Attractive Stocks lists.

Figure 2:  Stock Rating Table for Most Attractive Stocks

Sources:   New Constructs, LLC

Stocks make our Most Dangerous list because they have:

  1. Poor-Quality Earnings based on:
    • Misleading earnings: rising and positive GAAP earnings while economic earnings are negative and falling; and
    • Low Returns on Invested Capital (ROIC).

AND

  1. Expensive Valuations based on:
    • Free-Cash Flow Yields[1] that are very low or negative;
    • Price-to-Economic Book Value (EBV)[2] ratios that are relatively high; and
    • Growth Appreciation Periods[3] (GAP) that are relatively high.

The above characteristics also qualify stocks for a ‘Very Dangerous’ or ‘Dangerous’ Rating, according to our Risk/Reward Rating system. Figure 3 below shows our stock rating table, which we include in the reports for each of the 3000+ companies that we cover. Stocks get a grade of 1 to 5 for each criterion, 5 being the worst and 1 being the best score. The Overall score is based on the average score of all five criteria. Stocks must get an average score of 4.25 or above to be rated Very Dangerous. For the most part, only Very Dangerous stocks qualify for our Most Dangerous Stocks lists.

Figure 3:  Stock Rating Table for Most Dangerous Stocks

Sources:   New Constructs, LLC

**Deriv­ing eco­nomic earn­ings from account­ing data is a dif­fi­cult and time-consuming task, pri­mar­ily because it requires ana­lyz­ing and extract­ing crit­i­cal infor­ma­tion from the Finan­cial Foot­notes. The Help Sec­tion of New Con­structs web­site walks you through ever step of the process. The first step is to cre­ate eco­nomic finan­cial state­ments, which are com­prised of:

  1. NOPAT (Net Oper­at­ing Profit After Tax)
  2. Invested Cap­i­tal cal­cu­la­tion and definition
  3. WACC (Weighted-Average Cost of Capital)

Once you have your eco­nomic finan­cial state­ments, then you can derive the eco­nomic value dri­vers that we use to mea­sure the true, under­ly­ing prof­itabil­ity of companies.

  1. ROIC (ROIC stands for Return on Invested Capital)
  2. Eco­nomic Profit/earnings (note EVA is same as Eco­nomic Profit)
  3. Free Cash Flow
  4. NOPAT Mar­gin
  5. Invested Cap­i­tal Turns

Figure 4 provides additional detail and explanation behind our stock ratings and the criteria and thresholds that drive them.

Figure 4:  Stock Rating Criteria Thresholds and Explanations

RatingExplanationChart

Sources:   New Constructs, LLC


[1] Free-Cash Flow Yields measure the % of the total value of the firm for which the Free Cash Flows of the firm account. The formula is FCF/Current Enterprise Value.

[2] Economic Book Value (EBV) measures the no-growth value of the business based on its annual after-tax cash flow. The Formula for EBV is: (NOPAT / WACC) + Excess Cash + Non-operating assets – Debt (incl. Operating Leases) – Value of Outstanding Stock Options – Minority Interests.

[3] Growth Appreciation Period measures the number of years, implied by the market price, that a company will grow its economic earnings. This measure assigns a numerical value to the width of the moat around a firm’s business.

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