Introduction to a new quantitative component for our stock reviews – the OFB factor

Oft-repeated feedback request that we associate a rating with our stock reviews. Heeding these comments, a new objective component for our stock reviews will be introduced to quantify the analysis. This will aid the reader judge whether the stock is a buy at a particular point in time. Going forward, the stocks reviewed will be rated based on its ability to meet our investment objectives. The intent with our stock investment portfolio is:

1. Ability to beat inflation by a significant margin,
2. Evade companies that are victims of corporate abuse,
3. Generate income (4-5% range) through dividends and options, and maintain reasonable liquidity,
4. Reduce volatility compared to the overall market, and
5. Have the capacity to increase dividends perpetually.

The stocks reviewed are rated objectively by these measures and the ratings averaged to arrive at the ‘OFB factor’, which is in the range of 1-10. Below is a detailed breakdown.

Measure for a stock’s ability to beat inflation: For a particular stock to consistently beat inflation, it

• Should be well managed,
• Possess a significant moat, and
• Sport a low valuation per the points below.

Since the first two factors cannot be quantitatively measured, the following fundamental criteria will be used to approximate this:

1. Return on Equity: Baseline - 15%, Rating Scale 1-10. For every percentage point (rounded) below 15% in return on equity, a point is deducted.e.g.– For the fictitious ABC Corporation with a Return on Equity at 11%, this value will be 6. (4 points reduced as the return on equity of 11% is 4% below the baseline value of 15%).
2. Net Margin: Baseline - 15%, Rating Scale 1-10. For every percentage point (rounded) below 15% in net margin, a point is reduced. e.g. – For ABC Corporation with a Net Margin of 8%, this value will be 3. (7 points reduced as the net margin of 8% is 7% below the baseline value of 15%).
3. Free Cash Flow: Baseline - 5%, Rating Scale 1-10. For every percentage point below 5% (rounded) of revenue in free cash flow, a point is lost. e.g. – For ABC Corporation with free cash flow at an outstanding 11%, this value will be 10. (No points charged as free cash flow is above the baseline number of 5%).
4. PEG Ratio (obtained by dividing the price-to-earnings ratio by the projected 5-year average growth rate): Baseline – 0.50, Rating Scale 1-10. For every 0.10 rise (rounded) of this value above the baseline, a point is charged. e.g. – For ABC Corporation with a PEG ratio of 0.77, this value will be 7. (3 points reduced as the PEG Ratio of 0.77 is 0.27, rounded to 3.0, above the baseline value of 0.50).

In our example with ABC Corporation, the ability to beat inflation is measured as the average of the above four values which is 6.0 (average of 4, 3, 10, and 7).

Measuring Corporate Abuse: Excessive executive compensation is the primary form of “detectable” abuse in the corporate world. As commented previously, it is egregious for executives to be compensated at tens and in some cases at even hundreds times the average worker pay. The classic defense to such returns is that they are entitled to be remunerated as a percentage of what the business brings in for building up the business. This is flawed logic and double dipping at best – the executives who are founders/owners are already rewarded through their ownership interest (stocks they own). Unfortunately, in present day corporate America this abuse is so commonplace that very few companies will get points for this measure.

Corporate Abuse: Baseline – 20, Rating Scale 1-10.

Using 20-times as the base figure, the rating will go down a point for every point the CEO compensation edges up. e.g. - For ABC Corporation with CEO pay at 25-times the average worker compensation, this figure will be 5. (5 points reduced as the CEO pay of 25 times is over the base figure of 20 by 5 points).

Measuring Income Generation and Liquidity: Dividends and options (covered calls and cash covered puts) are expected to contribute equally towards income generation in the vicinity of 4 to 5%. To come up with a rating equal weightage is given to the factors contributing to this valuation as explained below:

1. The yield of the stock: Baseline – 5%, Rating Scale 1-10. The rating will decrease by a point for every percentage decline in dividends. e.g. – For ABC Corporation with a dividend yield of 2%, this figure will be 7. (3 points reduced as the dividend yield of 2% is 3% below the baseline of 5%).
2. The optionable nature of the stock: Baseline – none, Rating Scale 1-10. If the stock is optionable, the optionable nature factor gets 10 points else zero. e.g. – For ABC Corporation which is an optionable security, this figure will be 10.
3. The liquidity of the security: Baseline – 500,000, Rating Scale 1-10. This algorithm is based on the average person’s tendency to buy and hold a few 100 shares of a security at a time. The baseline used is the average 3-month volume. For every 50,000 reduction in the average volume a point is deducted. e.g. – For ABC Corporation with an average volume of 200,000, this figure will be 4. (6 points reduced, as the an average volume of 200,000 is 300,000 below the baseline number of 500,000).

For ABC Corporation, the income generation and liquidity measure will be the average of the above three figures, which is 7 (average of 7, 10, and 4).

Measuring Volatility: Measuring volatility is not straightforward for it is impossible to quantify stock price variances in the future. Many investment circles commonly consider Beta as a measure of stock’s volatility – but Beta is a measure of perceived future risk based on historical price fluctuations as opposed to actual future risk.

Our volatility rating is arrived at by averaging the beta number along with the ratio of debt to equity factor and the earnings growth consistency factor as explained below:

1. Beta: Baseline – 1.0, Rating Scale 1-10. For every 0.5 increase in beta over 1.0 a point is deducted. e.g. – For ABC Corporation with the Beta figure at 2.0, this factor will be 8. (2 points reduced, as the Beta of 2.0 is 1.0 above the baseline number of 1.0)
2. Ratio of debt to equity: Baseline – 0.50, Rating Scale 1-10. For every 0.25 increase in this ratio above 0.50 a point is decreased. e.g. – For ABC Corporation with debt to equity ratio at 0.75, this figure will be 9. (1 point reduced as the debt to equity ratio of 0.75 is 0.25 above the baseline number of 0.50)
3. Earnings growth consistency: Rating Scale 1-10. The earnings for the previous 5 years are considered and for every year the earnings did not appreciate a point is reduced. Negative earnings cost two points. e.g. – For ABC Corporation which reported earnings growth in three of the last five years, a loss one year, and no earnings growth in another year, this figure will be 7. (2 points reduced for the loss and 1 point reduced for the no earnings growth within the last 5 years).

For ABC Corporation, the volatility rating will be the average of the above three figures, which is 8 (average of 8, 9, and 7).

Measuring Capacity to Increase Dividends: The following individual readings contribute equally in calculating a company’s ability to increase dividends:

1. Current Payout Ratio: Baseline – 0.50, Rating Scale 1-10. For every 0.05 increase in the payout ratio over the baseline figure of 0.50 a point is reduced. e.g. – For ABC Corporation with a payout ratio of 0.70, this figure will be 6. (4 points reduced as the Payout Ratio of 0.70 is 0.20 above the baseline number of 0.50).
2. 5-year Average Dividend Growth: Baseline – 10%, Rating Scale 1-10. For every point decrease from a 5-year Average Dividend Growth rate of 10% a point is reduced. e.g.: – For ABC Corporation with a dividend growth rate of 12%, the figure will be 10. (No points reduced as the Dividend Growth rate of 12% is above the baseline number of 10%).
3. 5-year Average Earnings Growth: Baseline – 10%, Rating Scale 1-10. For every point decrease from a 5-year average earnings growth rate of 10% a point is reduced.e.g. – For ABC Corporation with an earnings growth rate of 12%, the figure will be 10. (No points reduced as the Earnings Growth rate of 12% is above the baseline number of 10%).

For ABC Corporation, the company’s ability to increase dividends is the average of the above three values which is 8.67 (average of 6, 10, and 10).

To arrive at our overall quantitative rating the ‘OFB rating’ for ABC stock, the above 5 values are averaged to arrive at 6.98 (6.25, 5, 7, 8, 8.67).  Since the overall figure came in at above 6, ABC is a good candidate for investment. Below is a summary spreadsheet showing OFB rating for ABC stock: