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”.
1) Business Strength: the quality of the economic earnings** of the company and the strength of its business model based on its ROIC.
a) Quality of Earnings measures how reported accounting income compares to the economic earnings of the company.
b) Return on Invested Capital (ROIC) measures the aggregate cash on cash returns of the company.
2) Valuation: based on the expectations embedded in stock prices. Investors should buy stocks with low expectations.
a) Free Cash Flow Yield measures the true cash yield of the company.
b) Price to Economic Book Value measures the growth expectations embedded in the stock price.
c) 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
You will find Figure 1 in every one of our Company 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:
- High-Quality Earningsbased on:
- Returns on Invested Capital that are rising; and
- Economic Earnings/Cash Flows that are positive.
- Cheap Valuations based on:
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
Stocks make our Most Dangerous list because they have:
- 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).
- Expensive Valuations based on:
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
**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:
- NOPAT (Net Operating Profit After Tax)
- Invested Capital calculation and definition
- 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.
- ROIC (ROIC stands for Return on Invested Capital)
- Economic Profit/earnings (note EVA is same as Economic Profit)
- Free Cash Flow
- NOPAT Margin
- 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
Sources: New Constructs, LLC
 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.
 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.
 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.