Scottish System Picks 12 Strong, Cheap Stocks

At the heart of the intrinsic value yield formula is a figure that represents cash earnings generated by a company over the past 12 months, less capital expenditures. This figure is a proxy for the earnings that could have been reasonably distributed by a conservative board of directors. Valu-Trac then grows those earnings by a historical growth rate, discounts them back to net present value to account for inflation, and divides them by the current price. It's like a classic dividend discount model, but the formula can be run on companies that do not distribute an actual dividend.

Valu-Trac defines distributable income as the "intrinsic value" of an equity share. By dividing the intrinsic value by the current price, it arrives at a figure that is somewhat similar to a cash earnings yield, or earnings divided by price (the inverse of the P/E ratio). A high intrinsic value yield is attractive because it means that distributable income is high and the price is low. As the stock price rises, the yield falls. So the best buying opportunities, Hess says, come when you find companies with high but falling intrinsic value yields coupled with rising price momentum.

How to Calculate IVY

I told you it was complex. It gets worse.

Here's how intrinsic value is calculated: Start with the latest 12-month operating earnings plus reported depreciation and amortization (i.e., cash earnings), then subtract the dividend, subtract a provision for maintenance capital expenditure, subtract a provision for growth cap-ex and divide by three. Now leave the company two-thirds of this amount, which amounts to gross free cash flow, add back the dividend, and you have the earnings a company could reasonably distribute, which Valu-Trac believes is the portion of earnings most relevant to shareholders.

Next, divide this intrinsic value figure by the latest price, compound it by the company's growth rate (explained in a moment), discount that number by the average national inflation rate of the past five years, and you get the intrinsic value yield. An adjustment to account for each sector's average intrinsic value yield is made before a final number is tallied.

So, what do they mean by growth rate? Not content with usual ways of projecting this figure because of the high level of hype, volatility and inaccuracy, Valu-Trac divides a company's five-year average return on equity by the market's five-year average return on equity and then multiplies that ratio by an evenly weighted blend of the local market's historical average earnings and GDP growth rates. This method rewards or handicaps companies that return more or less equity to shareholders than their average peer, and Valu-Trac believes it helps analysts maintain objectivity.