A Formula for Best Dow 30 Stocks for '07

Earnings drive stock prices, of course, but so do changes in the yield curve.

If, for example, institutions start snapping up bonds because of a sharper-than-expected drop in durable-goods orders (which imply an easing of inflation pressures), bond prices will rise, causing yields to fall. These new, lower yields make corporate earnings and dividends more valuable in relation to their fixed-income counterparts, causing equities to rally. But if, say, the bond market fears energy costs are poised to spiral higher, then bonds will get dumped, resulting in higher yields and making stocks less desirable.

Because stocks compete against bonds, the smart money habitually compares the relative value of ownership to debt.

To help you think like Wall Street's cognoscenti, there is a formula that expresses a company's stock on the same basis as a bond's yield-to-maturity. The equity yield-to-maturity, as I have dubbed this formula (EYTM, for short), is a measure of an owner's prospective total return, expressed in percentage terms. The higher the EYTM, the better.

My formula, which is based on material presented in a fine book entitled The Investor's Equation by William Bowen IV and Frank Ganucheau III, is equal to the sum of a firm's current yield and its expected growth:

• EYTM = Yield + Growth

Where,

• Yield = (ROE x Payout ratio)/(Price-to-book ratio)
• Growth = ROE x Reinvestment Rate

To illustrate, let's look at General Electric (GE - commentary - Cramer's Take), the most widely held stock in the Dow Jones Industrial Average.

Case Study: GE

• Stock price: $35
• Earnings per share: $1.65
• Book value per share: $10.81
• Dividend per share: $1.00

GE's current yield is 2.9% and its hypothetical growth is 6.01% annually, resulting in an 8.9% EYTM.

How do the other Dow Jones Industrials fare? We'll get to them in a moment.

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At the time of publication, Heiserman was long Exxon Mobil, although holdings can change at any time.

Hewitt Heiserman conceived the Earnings Power Chart and the Earnings Power Staircase. A graduate of Kenyon College with distinction in history, Heiserman is a member of the Boston Security Analyst Society and the CFA Institute. He also authored It's Earnings That Count. For additional information, please visit www.earningspower.com. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback; click here to send him an email.

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