What is the Fundamental Rule of Thumb Screen?
The Fundamental Rule of Thumb Screen has no single famous author. It is an old value shortcut that packs three well-worn measures — earnings yield, an adjusted return on equity, and dividend yield — into one number and ranks companies by it. The value tradition is full of one-line rules like "buy stocks with a P/E below the market" or "look for a PEG under one." This screen is that kind of quick composite: rather than pass or fail a stock on any single ratio, it adds the three together into a Fundamental Rule of Thumb value and keeps the highest scorers as candidates for real analysis.
The core idea
Every value investor wants the same three things: a low price, real growth, and income. The problem is that growth and dividends pull against each other — a dollar paid out as a dividend is a dollar not reinvested in the business. The score finesses that tension by summing three ratios, so a company can qualify through whichever combination it has. Exceptional growth can make up for a small or absent dividend; a generous dividend and a low price can make up for modest growth.
- Earnings yield = trailing earnings per share ÷ price. It is the reciprocal of the P/E, so an 8% earnings yield equals a P/E of 12.5. Higher means cheaper.
- Earnings retained to book = (earnings per share − dividends per share) ÷ book value per share. This is an adjusted return on equity — the return the company earns on shareholder capital after paying its dividend, a proxy for growth funded from within.
- Dividend yield = indicated dividend per share ÷ price. The income you are paid to wait.
Add the three. AAII suggests a combined value of at least 25% before a stock is worth a second look. A quick example shows how the pieces trade off: a company at a P/E of 20 — a 5% earnings yield — that pays no dividend needs an earnings-retained- to-book ratio of at least 20% to clear the 25% bar. With no dividend, that figure equals its return on equity, and a 20% ROE is a strong number.
What the screen looks for
- Fundamental Rule of Thumb value = earnings yield (trailing 12 months) + earnings retained to book + dividend yield.
- Total-liabilities-to-total-assets ratio for the latest quarter at or below the industry median — a guard against a score inflated by debt.
- Only the 50 companies with the highest Fundamental Rule of Thumb values reach the final list.
- Over-the-counter (OTC) stocks and American depositary receipts (ADRs) are excluded.
- Miscellaneous financial-services and real-estate-operations companies are excluded, since book value and leverage behave differently there.
Why it can work
Earnings yield is the anchor. Warren Buffett has long treated stocks as bonds with variable yields, comparing a company's earnings yield to the yield on high-grade or government bonds to judge whether the price is sane. The retained-to-book term rewards companies that compound equity through their own profits rather than through borrowing. Because two of the three terms are divided by price, a falling share price mechanically lifts the score — the ranking leans toward genuinely cheap names. Since it can compare a fast grower against a mature dividend payer on one scale, it works as a cross-industry first pass for combing through a large universe.
What to keep in mind
A rule of thumb is a rough first cut, and this one is honest about it. Book value is the weak leg: for asset-light, service, or intangible-heavy firms, the balance sheet understates the real capital base, so retained-to-book overstates the return. Heavy leverage does the opposite — it shrinks book value and inflates the ratio while adding risk, which is exactly why the screen caps liabilities at the industry norm. The earnings yield uses trailing EPS, so a one-time gain or a cyclical peak can flatter it. And the score adds a dollar of dividend yield to a dollar of retained return as if they were the same thing. It ranks; it does not value. Treat a high score as a reason to open the annual report, not to buy.
Sources
The screen combines classic value measures — earnings yield, return on equity, and dividend yield — drawn from the fundamental analysis tradition of Graham and Dodd and later popularized by investors such as Warren Buffett. It is not tied to a single book.
American Association of Individual Investors (AAII) — Stock Investor Pro screen definition and commentary.