My gradation of ratings goes like this: Very Attractive -> Attractive -> Neutral -> Unattractive -> Very Unattractive, with a corresponding 1 to 5 numerical rating. The ratings are given based on two broad factors, “a firm’s “Earnings Quality” in the last twelve months (LTM) and “Valuation” per the current price. The final stock rating is based on the average numerical rating of the five ratings I assign under these two factors, rounded to the nearest whole number. When I release a spreadsheet, the prices in it are live, so the reader should be able to work out what the appropriate rating is. I may update the spreadsheet without necessarily issuing a stock update.
The table below shows the elements that go into a rating:
Earnings Quality is determined by the evolution and level of reported earnings per share against economic profits1and ROIC, while Valuation is determined by the free cash flow (FCF) yield, the price-to-economic book value, and the market-implied competitive advantage period (MICAP), which I determine through my reverse discounted cash flow (DCF) model.
I look for businesses that are either attractive or very attractive according to this demanding rating system.
An example of how I have rated businesses are Meta Platforms, which scored a "False Positive" under Economic v Reported EPS, because its accounting earnings, at $17.41 per share, greatly overstated its economic profits, at $15.69 per share. Meta's ROIC, at 34.31%, is obviously top quintile, and its FCF yield is currently 2.97%, which earns a neutral rating, its PEBV at 2.06 is also neutral, and its MICAP, at 14 years, is also neutral. Diamond Hills, on the other hand, had accounting earnings of $14.51 per share, compared to economic profits of $11.49 per share, also earning a "False Positive". It has a ROIC of 36.2%, also top quintile, an FCF yield of 5.27%, which is attractive, a PEBV of 0.88, which is very attractive, and a MICAP of less than a year, which is also very attractive. This earned Diamond Hills an attractive rating from me.
- Economic profit is calculated by multiplying the economic profit margin, or return on invested capital (ROIC) minus the weighted average cost of capital (WACC) by invested capital ↩︎