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The ultimate objective of our IDEAL (Investing Daily Equity Analysis List) system is to provide investors with a helpful tool to identify stocks to buy, and stocks to avoid. Most self-directed investors have an objective of “beating the market”, and from a purely mathematical perspective to do that they need to own more stocks that will perform above average, and less that will perform below average. That is what the IDEAL stock rating system is designed to do, and we look forward to using it in the years to come to help you achieve your investment goals.
Although we have always believed that every company needs to be subjectively evaluated on its own merits, we also think it makes sense to limit the pool of potential portfolio additions to only those stocks that possess the critical traits that from a historical perspective have contributed most highly to success. That’s why we rate every company based on three variables: (1) dividend yield; (2) change in net operating cash flow; and (3) forward P/E ratio compared to its GICS sector peer group.
From a long-term perspective, dividends have accounted for over half of the total return of the stock market. So, if you own stocks that pay little or no dividend, you are effectively limiting your potential return to less than half of what it might otherwise be. When bond yields are high, income investors are less likely to buy stocks unless their dividend yield is even higher – otherwise, it isn’t worth the risk of owning the stock. For that reason, we assign a score on a scale of 0 – 3 for dividend yield based on how a stock’s yield compares to the yields currently available from U.S. Treasury notes. As the yield curve for treasury notes moves up and down, so does our scale to reflect the relative attractiveness of current dividend yields compared to what else is available in the market.
In order to pay dividends and still have enough cash left over to invest in the growth of the business, a company must be able to grow its net operating cash flow on a consistent basis. Without more cash coming in at the top, everything beneath that suffers including capex budgets, M&A activity, and the ability to attract and retain the best employees. We assign a score on a scale of 0 – 3 for cash flow based on the rate of change over the most recent four quarters, compared to the average for the two years prior to that. If the trend is negative, then that’s a huge red flag and no points are awarded. But if the trend is upward, then at least we know the company has the cash necessary to remain competitive.
In the near term, the single most critical factor is the extent to which a stock is fairly priced given its financial condition. There are many ways to measure that, but we look at the forward estimated 12-month P/E ratio since that reflects what is expected to happen in the future, not what has occurred in the past. If a company is trading at a premium to its sector peer group, then we assign no points for that. But if it is trading at a discount, then we award points on a scale of 0 – 4 based the degree to which it is below the average.
In total, the lowest score a stock can receive is 0, and the highest is a perfect 10. As a general rule, we recommended selling any stock with a total score of 0 – 2 since it would only take a little bit of bad news to send it into a downward spiral. We also limit our list of potential new buy candidates to those with a total score of 7 – 10, as they tend to appreciate more quickly on any good news. However, that doesn’t mean that every stock with a high score is necessarily a buy, as there may be other factors not measured by our system that need to be considered. The IDEAL Value for a stock is its current share price multiplied by a factor where the numerator is the IDEAL score for that stock and the denominator is the average IDEAL score for the entire S&P 500 Index.