Rivkin's top 5 US value stocks revealed
Let's tackle the obvious question at hand – how does one select 'value' stocks? This is what we've spent a great deal of our development time to determine. Our research has shown two critical factors that help to find strong companies.
Firstly, accruals have been shown to be a predictor of earnings stability. Accruals relate to sales made by a company for which payment has not yet been received and total accruals can be measured by the difference between accounting earnings and underlying cash flow. Companies with high accruals will have large accounting earnings, relative to cash flow. Research has shown that companies with lower levels of accruals have more sustainable earnings.
Next, by applying a measure of capital efficiency, we get closer to defining true value. We found a good measure of capital efficiency to be the return on capital employed, which measures the amount of returns generated for each unit of capital employed in the business of generating profit. The mathematical equation for this is operating earnings divided by capital employed, which includes the common equity, long and short-term debt, minus any cash in the bank. Therefore, this measure finds companies that are efficient in their use of capital.
Once the stock universe is screened based on the above two criteria, a final rank based on earnings yield can be performed. The earnings yield is simply the inverse of the more commonly known P/E ratio. The P/E ratio measures a company's share price, relative to its earnings.
Companies with a high earnings yield are 'cheap' relative to their share price and may, therefore, represent good value. (A note of caution here, high earnings yields can also be indicative of some other problem with the company. Our model, however, aims to screen out these problematic companies using the two fundamental screens, described above).