Our Stock Rating System

A Detailed Review of How We Rate Stocks

Our Stock Ratings outperform Wall Street analysts’ ratings – as proven by Harvard Business School. Our Stock Ratings get their edge from our more disciplined approach, superior fundamental data and financial models – as proven by The Journal of Financial Economics and Ernst & Young. Our Long Idea and Danger Zone picks are consistently ranked #1 and are regularly fea­tured by all major media outlets.

We assign one of five ratings to every stock under coverage: Very Attractive (best rating), Attractive, Neutral, Unattractive, Very Unattractive (worst rating). The same rating system also applies 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: “Quality of Earnings” and “Valuation”. Quality of earnings ratings are based on data in the trailing twelve month period from a company's latest 10-Q or 10-K. Valuation ratings are based on a stock's latest closing price.

Figure 1 shows our standard Risk/Reward Rating table for Apple Inc. (AAPL).

Figure 1:  Stock Rating Table

Sources: New Constructs, LLC

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

1. Economic Vs. Reported EPS 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.

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

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

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

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 Unattractive’ or ‘Unattractive’ 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 Unattractive. For the most part, only Very Unattractive stocks qualify for our Most Dangerous Stocks lists.

Figure 3:  Stock Rating Table for Most Unattractive 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 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

FCF Yield Ratings Thresholds Explanation

The thresholds for our FCF Yield Ratings are based on our research that showed stocks for companies with FCF Yields >10% were the strongest performers over the long term. We found that stocks for companies with meaningfully positive FCF Yields performed well albeit not as well as those with >10%. Stocks for companies with FCF Yields that were around 0% did not perform very well (albeit better than those with highly negative FCF Yields).

PEBV Ratio Ratings Thresholds Explanation

The thresholds for our PEBV Ratio Ratings are based on our research that showed stocks for companies with PEBV Ratios between 0 <1.1 were the strongest performers over the long term.

Note that stocks for companies with PEBV Ratios between -1 < 0 tend to perform worse than those with PEBV Ratios <-1 because their companies have more negative NOPATs. These ratings are not as intuitive as some of our other ratings because the PEBV Ratio Rating does not get worse as it becomes a larger negative value. The worst PEBV ratios are between -1 < 0.

Here's the math to explain the non-linear relationship nature of our PEBV Ratio Ratings:

Assume two companies with the same 10% WACC, no assets/liability adjustments, and the same stock price of $10/share. Company A’s NOPAT equals -$50, Company B’s NOPAT is -$1. The economic book value for Company A is -$500 and its PEBV Ratio would be -0.02. The economic book value for Company B is -$10 and its PEBV Ratio would be -1.

Company A, with a more negative NOPAT and worse profitability, has a higher PEBV Ratio than Company B, with less negative NOPAT. The larger the negative NOPAT, the closer the PEBV Ratio gets to zero. On the other hand, the closer NOPAT gets to zero, while still negative, the more negative the PEBV Ratio gets. For a third example, Company C’s NOPAT is -$0.01. Using the same assumptions as we did for Companies A & B, Company C’s PEBV Ratio is -100.

[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.

This paper compares our analysis on a mega cap company to other major providers.

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