Proof That Valuation Metrics Matter

A Valuation Scoring System for S&P 5 Star Stocks

How much do valuation metrics matter in stock picking? It is a very important question considering how far the S&P 500 has come since the October 2011 lows. When scouting trades, my bread and butter has always been identifying high probability chart patterns and reviewing fundamentals to make sure a value component exists. However, at these lofty S&P levels, juicy chart patterns seem to be few and far between. Once a market begins trending in a stable low range environment (usually after a period of high volatility), a trader can easily get left behind simply because traditional setup patterns cease to exist.

So, to address the "lack of traditional chart patterns" in the market, I created a simple system that pushes fundamental analysis to the forefront of my stock selection criteria. I'm writing this blog entry because, along the way, I discovered something pretty cool which hopefully you can use. Let's get to it!

Via my Ameritrade stock screener, I created a list of 75 stocks rated "5 Stars" by Standard and Poors. This is S&P's highest rating and will serve as "safety filter" on my universe of stocks. Next, I loaded the stocks into Finviz here. My objective was to find the cheapest 5 star S&P stocks using various valuation metrics. I selected my metrics within Finviz, ran the screen, and downloaded the following spreadsheet (screenshot):

Using a simple ranking and scoring system, I gave each stock a rank/score for each valuation metric. For example, $HFC had the lowest Price/Earnings Growth (PEG) metric so I gave that stock a "1". The stock with the highest PEG was $CBL, so I gave it a "75". In other words, I computed a score for each stock across these 7 different valuation metrics:

• Price/Earnings
• Forward P/E
• PEG (price to earnings growth)
• Price/Sales
• Price/Book
• Price/Cash
• Price/Free Cash Flow

Then, I added up the total scores for each stock to get a "Composite Valuation Score" (see screenshot):

Finally, I sorted the stocks by my Composite Valuation Score. The lower the score, the cheaper the stock. I decided to add Year to Date performance to my spreadsheet and do a correlation between composite valuation and performance. And guess what I found? Yep, valuation does matter! The stocks that had a lower composite valuation score have *significantly* higher year to date performance. In other words, it pays to search for value.

Here are the top 20 cheapest 5 star S&P stocks:

Please feel free to ping me on StockTwits at PTSD_Trader if you would like a copy of the spreadsheet. I can't seem to figure out how to upload it via Blogger.com :)