1. Precision Filter
This filter removes some types of stocks that belong to categories that are difficult to analyze by a value-investing quantitative strategy. These include:
- ADR: An American Depositary Receipt Stock or ADR/ADS is a foreign stock that allows U.S. investors to trade its shares on a U.S. exchange. Financial data for these types of stocks are more subject to errors due to currency conversions and many other factors. Therefore, they are excluded.
- Finance, Utilities, REIT Sector: Companies belonging to these sectors are typically valued with other types of metrics than common stocks and, therefore, can’t be included in a generic quantitative formula.
- Small Caps: Even though the Everest Formula can be used to analyze these types of companies, they are excluded from the official strategy because the formula works better with mid and large caps due to the better reliability and accuracy of the quantitative analyses. Unlike Magic Formula, the minimum market cap threshold is dynamically computed based on the current market condition.
Companies not belonging to the above categories can proceed to step 2.
2. Quality Filter
This filter ensures that the companies are “good”, i.e. with a high return on capital, high profitability, and low debt.
The filter makes use of the following metrics:
- Return On Tangible Capital Employed (ROTCE): The most consistent indicator to measure the profitability of a business and how well the management is able to transform the capital employed into value for the shareholders. For more information on ROTCE, visit the FAQ.
- Net Debt On Free Cash Flow: Everest’s best indicator to value a company’s debt: how many years of the company’s cash flow are needed to cover its net debt (total debt – cash). This is the same indicator Phil Town uses in its book Rule#1 to filter companies with acceptable debt.
- Positive Income, Positive Tangible Book Value, Positive Free Cash Flow in recent years: To be considered “good”, companies must demonstrate a stable financial situation. These metrics set a checkpoint on this trait.
These metrics are weighted and mixed to get a quality score. Companies whose score passes a threshold can proceed to step 3.
3. Valuation Filter
This filter ensures that passed companies are not “overvalued” companies, i.e. stocks that would be paid too much to be acquired.
The filter makes use of the following metrics:
- Price/Earnings (PE) Ratio: this is the most widely-used ratio to determine the valuation of a company against its historical record or to the aggregate market. It indicates the dollar amount an investor can expect to invest in a company to receive one dollar of its earnings.
- Price/Sales (PS) Ratio is a valuation ratio that compares a company’s stock price to its revenue. It shows how much investors are willing to pay per dollar of sales.
- Ebit/Enterprise Value Ratio: The Greenblatt Magic Formula’s way to value a company. The basic idea behind the concept of earnings yield is to figure out how much a business earns relative to the purchase price of the business.
These metrics are weighted and mixed to get a valuation score. Companies whose scores pass a threshold can proceed to step 4.
4. Valuation Rank
Finally, the “survived” companies are ranked based on the Everest most important indicator to value a company: the Free Cash Flow/Enterprise Value, i.e. The Free Cash Flow Yield.
As Investopedia says, the Free Cash Flow Yield is “The best fundamental indicator”. Dividing the free cash flow that a company generates by its value, we get the best measure of its performance.
Investors are interested in the amount of cash the company receives in its bank accounts, as these numbers show the truth of a company’s performance. It is more challenging to hide financial misdeeds and management adjustments in the cash flow statement.
Cash flow is the measure of money into and out of a company’s bank accounts. Free cash flow, a subset of cash flow, is the amount of cash left over after the company has paid all its expenses and capital expenditures (funds reinvested into the company).
When free cash flow is positive, it indicates the company is generating more cash than is used to run the business and reinvest to grow it. Therefore, it’s fully capable of supporting itself, and there is plenty of potential for further growth.
Free cash flow is similar to earnings for a company without the more arbitrary adjustments made in the income statement. For this reason, FCF/EV is a more reliable indicator than the PE Ratio.
As the final result of the four steps, we have found good businesses available at bargain prices. That’s the best way to invest in the stock market.
