Investing research can be overwhelming. This is especially true for novice investors; there are just so many metrics to consider, and they all relate to each other in a large and complex whole, so how can one make sense of a set of investments and compare them?
This article is meant to provide a quick organization viewpoint in regards to scanning dividend stocks. It’s not meant to be an all-inclusive guide on how to select a company, but it provides what I consider to be among the most important investing criteria, and how they relate to each other. Some businesses, such as financial companies and partnerships will require a different set of metrics, but these work well for a large collection of dividend stocks out there.
Generally, things like solid growth prospects, strong balance sheets, and positive subjective information will lead to higher reasonable valuations for a company. So when analyzing a company, I look to find a company with decent growth prospects, a strong financial position, positive subjective information, and shareholder friendly management, and then I look to see if the valuation is reasonable given this total information.
Growth:
Net Income Growth
Revenue Growth
EPS Growth
FCF compared to Net Income
Return on Equity
Net Income Growth
Revenue Growth
EPS Growth
FCF compared to Net Income
Return on Equity
Financial Strength:
Debt/Equity
Interest Coverage Ratio
Goodwill/Equity
Current Ratio
Debt/Equity
Interest Coverage Ratio
Goodwill/Equity
Current Ratio
Dividend Information:
Dividend Yield
Dividend Payout Ratio
Dividend Growth
Share Repurchases
Dividend Yield
Dividend Payout Ratio
Dividend Growth
Share Repurchases
Subjective Information:
Business and Industry Prospects
Economic Advantage
Management Quality
Business and Industry Prospects
Economic Advantage
Management Quality
Valuation:
Price-to-Earnings (P/E) Ratio
Price-to-Free-Cash-Flow (P/FCF) Ratio
Price-to-Book Value
Market Capitalization
Price-to-Earnings (P/E) Ratio
Price-to-Free-Cash-Flow (P/FCF) Ratio
Price-to-Book Value
Market Capitalization
Growth
A company can grow in many ways, so looking at a variety of growth metrics is important.
Net Income Growth
Income is the bottom line that business owners are after. Companies operate to bring in profits, and profits ideally grow over time. It’s useful to look at net income growth over 3-year, 5-year, and 10-year periods to get an idea of what kind of long-term growth prospects this company may have, and how the trends are changing (is growth slowing or accelerating, or neither?)
Income is the bottom line that business owners are after. Companies operate to bring in profits, and profits ideally grow over time. It’s useful to look at net income growth over 3-year, 5-year, and 10-year periods to get an idea of what kind of long-term growth prospects this company may have, and how the trends are changing (is growth slowing or accelerating, or neither?)
Revenue Growth
In many cases, it’s important to look for revenue growth as well. If a company is growing net income but not revenue, it means they are becoming more efficient and therefore increasing their profit margins, but this can only go so far. For sustained growth of net income, sustained revenue growth is required.
In many cases, it’s important to look for revenue growth as well. If a company is growing net income but not revenue, it means they are becoming more efficient and therefore increasing their profit margins, but this can only go so far. For sustained growth of net income, sustained revenue growth is required.
EPS Growth
To investors, growth of earnings-per-share is typically even more important than net income growth. If a company grows its net income, while using some of its money to repurchase its own shares, then EPS will grow faster than net income. If, on the other hand, a company is diluting its shares by issuing more shares than it is repurchasing, EPS will grow more slowly than net income. In addition, EPS may be growing even if net income is flat or decreasing, so it’s important to look at both per-share metrics and total company metrics.
To investors, growth of earnings-per-share is typically even more important than net income growth. If a company grows its net income, while using some of its money to repurchase its own shares, then EPS will grow faster than net income. If, on the other hand, a company is diluting its shares by issuing more shares than it is repurchasing, EPS will grow more slowly than net income. In addition, EPS may be growing even if net income is flat or decreasing, so it’s important to look at both per-share metrics and total company metrics.
FCF compared to Net Income
A company that maintains solid free cash flow numbers is a sign of health and economic advantage. If a company can maintain profitability and growth with minimal capital expenditure, then it’s likely performing quite well. I look for operational cash flow to be substantially higher than net income, and for free cash flow to be either higher than net income, or at least comparable to it, in most investments. It depends to a certain extent on the industry.
A company that maintains solid free cash flow numbers is a sign of health and economic advantage. If a company can maintain profitability and growth with minimal capital expenditure, then it’s likely performing quite well. I look for operational cash flow to be substantially higher than net income, and for free cash flow to be either higher than net income, or at least comparable to it, in most investments. It depends to a certain extent on the industry.
Return on Equity (ROE)
When you divide net income of a company by their total shareholder equity, you get return on equity. Typically, higher returns on equity are a sign of competent management and a profitable business, because they are bringing in a lot of income for each dollar that is on the balance sheet. One must be careful, though, because a bad balance sheet can sometimes boost returns on equity. If a company has a large amount of liabilities compared to assets (and therefore a small amount of shareholder equity), then ROE will seem quite high. So it’s important to look at the whole picture, and compare ROE to financial strength metrics.
When you divide net income of a company by their total shareholder equity, you get return on equity. Typically, higher returns on equity are a sign of competent management and a profitable business, because they are bringing in a lot of income for each dollar that is on the balance sheet. One must be careful, though, because a bad balance sheet can sometimes boost returns on equity. If a company has a large amount of liabilities compared to assets (and therefore a small amount of shareholder equity), then ROE will seem quite high. So it’s important to look at the whole picture, and compare ROE to financial strength metrics.
Financial Strength
A company that is in good financial shape reduces risk, provides opportunity, and shows management responsibility. All else being equal, a company with a strong balance sheet is worth more than a company with a weak one.
Debt/Equity
Debt/Equity is an important metric. Long-term Debt/Equity is calculated by taking the total amount of long-term debt and dividing it by the amount of shareholder equity. The lower the number, the less debt the company has compared to equity. I prefer companies with less than 0.5 debt/equity ratios, or at least less than 1.0 debt/equity ratios, but it will vary to a certain extent in some industries. Companies that necessarily have large amounts of capital expenditure will usually have substantial debt levels.
Debt/Equity is an important metric. Long-term Debt/Equity is calculated by taking the total amount of long-term debt and dividing it by the amount of shareholder equity. The lower the number, the less debt the company has compared to equity. I prefer companies with less than 0.5 debt/equity ratios, or at least less than 1.0 debt/equity ratios, but it will vary to a certain extent in some industries. Companies that necessarily have large amounts of capital expenditure will usually have substantial debt levels.
Interest Coverage Ratio
If a company holds debt, it’s paying interest on that debt. A company with a lot of debt will be paying a lot of interest, but other factors matter too. A company with a strong balance sheet and a good credit rating generally pays lower interest rates than a weaker company, and so a metric is needed to sort out different situations. If you take income before taxes and divide it by the amount the company pays in interest over that time period, you’ll get the interest coverage ratio. I typically look for companies with an interest coverage ratio of at least 3, but prefer to see it over 8 or more.
If a company holds debt, it’s paying interest on that debt. A company with a lot of debt will be paying a lot of interest, but other factors matter too. A company with a strong balance sheet and a good credit rating generally pays lower interest rates than a weaker company, and so a metric is needed to sort out different situations. If you take income before taxes and divide it by the amount the company pays in interest over that time period, you’ll get the interest coverage ratio. I typically look for companies with an interest coverage ratio of at least 3, but prefer to see it over 8 or more.
Goodwill/Equity
Some assets are called “goodwill”, which is an accounting asset rather than a real one. When a company pays more for a company than its book value, they put the remainder on their balance sheet as goodwill, and management is responsible for deducting from it as appropriate. If a company has a lot of goodwill, it can artificially lower metrics like debt/equity. On the other hand, goodwill isn’t necessarily a bad thing if it is accurate. Some companies, especially those prone to making acquisitions, will naturally hold more goodwill than others. Dividing the total goodwill by the total equity shows what percentage of equity consists of goodwill. All else being equal, it’s optimal to look for fairly low or moderate levels of goodwill.
Some assets are called “goodwill”, which is an accounting asset rather than a real one. When a company pays more for a company than its book value, they put the remainder on their balance sheet as goodwill, and management is responsible for deducting from it as appropriate. If a company has a lot of goodwill, it can artificially lower metrics like debt/equity. On the other hand, goodwill isn’t necessarily a bad thing if it is accurate. Some companies, especially those prone to making acquisitions, will naturally hold more goodwill than others. Dividing the total goodwill by the total equity shows what percentage of equity consists of goodwill. All else being equal, it’s optimal to look for fairly low or moderate levels of goodwill.
Current Ratio
The current ratio is calculated by taking total current assets (cash, short-term investments, receivables, etc) and dividing by total current liabilities (payables, short-term debt, etc). This should typically be above 1, and I prefer to see a higher number in smaller companies.
The current ratio is calculated by taking total current assets (cash, short-term investments, receivables, etc) and dividing by total current liabilities (payables, short-term debt, etc). This should typically be above 1, and I prefer to see a higher number in smaller companies.
Dividend Information
To dividend investors, researching the dividend is obviously of immense importance. One wants a significant dividend yield, a growing dividend, but a payout ratio that is low enough to increase the likelihood that the dividend remains safe and growing.
Dividend Yield
To calculate the dividend yield, take the amount that the company pays in dividends per share each year and divide that amount by the share price. Typical dividend investments typically pay 2.5% to perhaps 7%, with 3-5% being a pretty good area. Yields under that are pretty low, and yields above that may be value traps.
To calculate the dividend yield, take the amount that the company pays in dividends per share each year and divide that amount by the share price. Typical dividend investments typically pay 2.5% to perhaps 7%, with 3-5% being a pretty good area. Yields under that are pretty low, and yields above that may be value traps.
Dividend Payout Ratio
An unsustainable dividend is not a very useful dividend. Divide the total yearly dividend by the EPS to get the earnings payout ratio. This represents the percentage of earnings that the company is paying to shareholders as dividends. It’s also worthwhile to divide the total yearly dividend by the per-share free cash flow to get the FCF payout ratio. Ultimately, it’s cash that determines dividend sustainability.
An unsustainable dividend is not a very useful dividend. Divide the total yearly dividend by the EPS to get the earnings payout ratio. This represents the percentage of earnings that the company is paying to shareholders as dividends. It’s also worthwhile to divide the total yearly dividend by the per-share free cash flow to get the FCF payout ratio. Ultimately, it’s cash that determines dividend sustainability.
Dividend Growth
Some companies pay the same dividend each year, some companies grow or reduce their dividends erratically, while others successful grow their dividend year after year. Seeing dividend growth trends can help determine future growth of your passive income and your yield on cost.
Some companies pay the same dividend each year, some companies grow or reduce their dividends erratically, while others successful grow their dividend year after year. Seeing dividend growth trends can help determine future growth of your passive income and your yield on cost.
Share Repurchases
Some companies repurchase their own shares, which means the existing shares that a shareholder owns are worth a greater percentage of the company (or the company can eventually issue the shares again for an acquisition). Companies typically also issue shares to executives for compensation. Looking at the net share repurchases of a company (repurchases minus issues), shows how much money the company is spending on share repurchases. It’s sometimes useful to compare this amount to how much they are paying in dividends. Share repurchases will boost EPS and fuel dividend growth, but can sometimes be used irresponsibly.
Some companies repurchase their own shares, which means the existing shares that a shareholder owns are worth a greater percentage of the company (or the company can eventually issue the shares again for an acquisition). Companies typically also issue shares to executives for compensation. Looking at the net share repurchases of a company (repurchases minus issues), shows how much money the company is spending on share repurchases. It’s sometimes useful to compare this amount to how much they are paying in dividends. Share repurchases will boost EPS and fuel dividend growth, but can sometimes be used irresponsibly.
Subjective Information
This is what separates humans from machines. Anyone can plug in the above numbers (and they should), but it takes someone with insight to figure out the rest. This is what separates good investors from mediocre ones, along with discipline and patience. This part of the investment process takes the most work.
Business and Industry Prospects
For long-term investments, it usually makes sense to pick a business that is in an industry that is not going to go away any time soon. A healthy and growing industry makes it easier for a company in that industry to grow and increase profitability. Likewise, even a great company in a struggling industry may find itself in trouble. Even the world’s best horse-and-buggy company will run into trouble if everyone starts driving cars. Sometimes an industry may seem to be in bad shape, but the long term is what’s important. Sometimes great values can be found in industries that are currently out of favor but that have great long-term potential.
For long-term investments, it usually makes sense to pick a business that is in an industry that is not going to go away any time soon. A healthy and growing industry makes it easier for a company in that industry to grow and increase profitability. Likewise, even a great company in a struggling industry may find itself in trouble. Even the world’s best horse-and-buggy company will run into trouble if everyone starts driving cars. Sometimes an industry may seem to be in bad shape, but the long term is what’s important. Sometimes great values can be found in industries that are currently out of favor but that have great long-term potential.
Economic Advantage
Some companies have advantages over others that separate them and allows them to achieve and maintain impressive levels of profitability. If companies compete against each other without economic advantages, they are essentially offering commodity products and services, and it often leads to the result that they will not be quite as profitable or have as much staying-power, as those that do have strong advantages. The popular explanation is that an economic advantage is a company’s moat, keeping competitors away with little work.
Some companies have advantages over others that separate them and allows them to achieve and maintain impressive levels of profitability. If companies compete against each other without economic advantages, they are essentially offering commodity products and services, and it often leads to the result that they will not be quite as profitable or have as much staying-power, as those that do have strong advantages. The popular explanation is that an economic advantage is a company’s moat, keeping competitors away with little work.
Examples of Economic Advantages include:
Scale: If a company is larger than others, it likely has more purchasing power, a more effective and efficient distribution network, and the ability to buy-out or out-spend competitors. Companies have trouble competing against scale because they lack scale themselves, and they cannot achieve scale unless they compete well, so it’s a vicious cycle.
Scale: If a company is larger than others, it likely has more purchasing power, a more effective and efficient distribution network, and the ability to buy-out or out-spend competitors. Companies have trouble competing against scale because they lack scale themselves, and they cannot achieve scale unless they compete well, so it’s a vicious cycle.
Switching Costs:
When it is difficult for a customer to switch to competitor’s product or service, they likely will not. It’s a hassle to change banks, to change infrastructure, and to change computer systems.
When it is difficult for a customer to switch to competitor’s product or service, they likely will not. It’s a hassle to change banks, to change infrastructure, and to change computer systems.
Regulation:
Some companies operate in such a way that they essentially have a regulated monopoly. Their risks and rewards are reduced and investments can potentially be more predictable.
Some companies operate in such a way that they essentially have a regulated monopoly. Their risks and rewards are reduced and investments can potentially be more predictable.
Intangible Property: People are willing to pay a little more money for the same product or service when they feel trust towards a brand. In addition, when a person is selecting a product or service seemingly at random, they are likely to pick one they are familiar with. Brand strength is an intangible benefit to many companies. Patent shields are also powerful defenses. When a company can patent its product or service, it keeps competitors away temporarily and allows high levels of profitability.
Management Quality
Lastly, it’s worthwhile to look at management quality. How long has the current CEO been running the company? How have they performed? How much of the company do the executives own? What is the company culture like? Having an outstanding group of individuals running a high-quality business can do wonders for your portfolio.
Lastly, it’s worthwhile to look at management quality. How long has the current CEO been running the company? How have they performed? How much of the company do the executives own? What is the company culture like? Having an outstanding group of individuals running a high-quality business can do wonders for your portfolio.
Valuation
The valuation of a company is the snapshot of what investors are willing to pay for this business at the current time. Fair valuation depends to a large extent on other metrics, and must be considered alongside them.
Price-to-Earnings (P/E) Ratio
The P/E ratio is the price of a share divided by the earnings-per-share. Because price is measured in dollars, and earnings are measured in dollars per year, the units for P/E are measured in years. A higher P/E ratio means that investors are currently paying more per unit of earnings, while a lower P/E means investors aren’t willing to pay very much per unit of earnings. Typically, my investment purchases have a P/E of between 10 and 20 with a few exceptions, and it varies based on a number of factors.
The P/E ratio is the price of a share divided by the earnings-per-share. Because price is measured in dollars, and earnings are measured in dollars per year, the units for P/E are measured in years. A higher P/E ratio means that investors are currently paying more per unit of earnings, while a lower P/E means investors aren’t willing to pay very much per unit of earnings. Typically, my investment purchases have a P/E of between 10 and 20 with a few exceptions, and it varies based on a number of factors.
Price-to-Free-Cash-Flow (P/FCF) Ratio
P/FCF is similar to P/E, except free cash flow per share is substituted for earnings. Free cash flow is the total amount of cash brought in by operations minus the amount of cash that was used for capital expenditure. It can sometimes be more truthful than earnings, but tends to be more volatile because management may spend more in capital expenditure in some years than others. Monitoring both income and cash flow is important to get a good grasp on how the company is really performing.
P/FCF is similar to P/E, except free cash flow per share is substituted for earnings. Free cash flow is the total amount of cash brought in by operations minus the amount of cash that was used for capital expenditure. It can sometimes be more truthful than earnings, but tends to be more volatile because management may spend more in capital expenditure in some years than others. Monitoring both income and cash flow is important to get a good grasp on how the company is really performing.
Price-to-Book Value
When you take a company’s total assets and subtract their total liabilities, you get the total shareholder equity, or book value. Book value per share is the total equity divided by the total number of shares. Tangible book value is the same, except it excludes intangible assets such as goodwill. If the company were to go out of business, the tangible book value is the theoretical amount each share would be worth. Different industries have different reasonable book values, because some types of businesses require more assets than others (think manufacturers vs. software).
When you take a company’s total assets and subtract their total liabilities, you get the total shareholder equity, or book value. Book value per share is the total equity divided by the total number of shares. Tangible book value is the same, except it excludes intangible assets such as goodwill. If the company were to go out of business, the tangible book value is the theoretical amount each share would be worth. Different industries have different reasonable book values, because some types of businesses require more assets than others (think manufacturers vs. software).
Market Capitalization
Market capitalization is the total number of shares multiplied by how much each share is currently worth. Theoretically, this is how much the market has decided the entire company is worth. It’s worth looking at, because investors often look to have a mix of big companies and smaller ones.
Market capitalization is the total number of shares multiplied by how much each share is currently worth. Theoretically, this is how much the market has decided the entire company is worth. It’s worth looking at, because investors often look to have a mix of big companies and smaller ones.
Conclusion
In conclusion, it takes a lot of work to thoroughly analyze a company. These metrics are a good start, and one will also need to delve into their annual reports, compare the company with competitors, research investing and public commentary on the company, and assess risk and potential growth catalysts.
When looking for a company to invest in, I look for a strong balance sheet, decent growth prospects, competitive advantages, a positive industry, shareholder friendly and competent management, and solid dividend information. I focus on long-term potential and total shareholder return.This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]