Showing posts with label investing. Show all posts

Sunday, March 13, 2022

Dividend Investing Strategy

Introduction

Owning shares of stock in a company that pays a dividend is a great way to generate passive income. The dividend is a stream of income you receive usually on a quarterly basis and the dividend income would be on top of any capital gain incurred when the company stock price increases.

When a dividend is paid out, you are getting a portion of the company profits. The dividend yield is one financial ratio important to compare when looking for dividend paying stocks.

Dividend yield explained.

The dividend yield is the percentage of the share price the company pays out dividends each year.

In December 2021, the dividend yield of the S&P 500 was 1.27%.

If you owned 1 share of the S&P 500 fund, you would receive $1.27 in dividends annually.

Stocks paying a dividend usually reward investors over the long term (5 – 10 years) as long as the company and industry are stable.

Dividend Investing Strategies

There a 3 common dividend investing strategies: 1) High Dividend growth rate, 2) High Dividend Yield, 3) Dividend Reinvestment Plans (DRIPS)

High Dividend Growth Rate

The high dividend growth rate strategy focuses on buying stock in companies that pay dividends but are growing the payout rapidly. With this strategy you are buying shares in a profitable company initially with a dividend payout that maybe low, however, as the company rapidly increases the dividend payout over a five- or 10-year period, you will make a large amount of income.

High Dividend Yield

The high dividend yield approach focuses on companies that are slowly growing and have a high cash flow. This usually allows the companies to fund large dividend payments that provide you with immediate income.

Dividend Reinvestment Plans (DRIPS)

Many brokers and companies paying dividends offer Dividend Reinvestment plans (DRIP). This allows you to reinvest your dividends to purchase more shares of stock instead of taking the dividend as cash.

The DRIP strategy focuses on companies that offer Dividend Reinvestment plans. Then analyzing and identifying high quality companies with safe dividends and starting the dividend reinvestment plan. Many folks use this strategy to invest for the long term. Once the dividend reinvestment plan is setup every dividend paid will reinvest in more shares of the company and will compound the income stream over time.

Before investing in dividend paying companies, you will need to understand the health of their business and verify the dividend payout is safe. It is important to do your own research before investing in the stock of a company.

Dividend Investing Financial Ratios

Several financial ratios are helpful in evaluating the performance of the underlying business. Financial ratios are calculations and/or metrics used to research and compare investment opportunities.

Many financial ratios are included in financial statements, annual reports, and investor presentations. Others you will need to calculate yourself. Examples of financial ratios include: Quick ratio, Current ratio, price to earnings, debt coverage, return on assets.

We now will review financial ratios that are helpful when evaluating dividend paying companies.

Dividend Payout Ratio

The dividend payout ratio measures the percent of a companies’ earnings paid out for the dividend. Companies with lower payout ratios are assumed safer. A divided from a company with a high payout ratio (above 75%) is assumed riskier since a majority of the company’s earnings are used to payout the dividend.

The dividend payout ratio formula is calculated as: Amount of Dividends paid / Earnings generated for time period.

If a company paid $3 in dividends in a year and earned $10 that year, the dividend payout ratio is: $3/$10 = 30%.

Dividend payout ratios of less than 60% are generally considered safe. A higher payout ratio could be considered if a business is extremely stable and the company maintains strong financial health. For example, a higher payout ratio maybe considered safe for a regulated utility business.

Reviewing the trend of the dividend payout ratio over time (3 – 5 years) is important to determine if the payout ratio is consistent or not. Companies with greater consistency in the payout ratio are generally safer.

Free Cash Flow

It is important to understand the free cash flow of the business. Free cash flow is the fuel for dividends and stock repurchases.

The calculation for free cash flow is:

Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital

Minus

Company Capital Expenditures (money spent on property, plant, and equipment)

Companies that generate free cash flow consistently in virtually every economic environment are much safer. And dividends from companies with consistent and growing free cash flow are considered safer and more reliable.

Operating Profit Margin

Generally speaking operating profits represent the company’s earnings before interest and taxes. This allows the analysis to focus on comparing the profitability of actual operations. A company with a high and stable operating profit margin is very desirable.

The formula for Operating Profit Margin is: Operating Profits / Total Sales

It is important to understand the level and consistency of the company’s operating profit margin. Company’s with high and stable operating profit margins are more desirable as they help earnings compound quicker.

Sales Growth

Trends in sales growth tell us about the stability or volatility of a company’s business model and the ability of it to continue to expand.

Companies with stable sales growth in different economic conditions are more desirable and their dividend safer.

Sales growth is calculated by subtracting one revenue period from another revenue period and expressing the difference as a percentage of the former period.

Example of Sales growth calculation. Company X sales in 2019 were $200. Company X sales in 2020 were $250.

Sales growth for company X in 2020 is calculated as ($250 – 200) / $200 = 25%.

It is important to look at both the level and consistency of sales growth over several years to determine the strength of the business model of the company.

Return on Invested Capital

Companies earning higher returns on invested capital are compounding capital faster and are considered more desirable companies to invest in.

Return on invested capital (ROIC) assesses a company's efficiency at allocating the capital under its control to profitable investments. Comparing ROIC to a company’s weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.

Return on invested capital measures a company’s return on equity and debt. Measuring a company’s return on both equity and debt, allows for a better comparison of companies with different capital structures.

The formula for Return on Invested Capital is: ROIC = NOPAT / Invested Capital

NOPAT = Net Operating Profit After Tax

Or another formula is Return on Invested Capital = (Net Income – Dividends) / (Debt + Equity)

It is important to look at both the level and consistency of Return on Invested capital over several years.

Companies with a stable, double digit return on invested capital over several years are more desirable to invest in and their dividends are considered safer.

Asset Turnover

Asset Turnover measures how many dollars of sales each dollar of assets generated. This tells us how efficiently is at generating sales from its assets.

The formula for Asset Turnover is: Total Sales / Total Assets

More profits can be generated by companies that generate great sales from their asset base. Companies with low operating margins can generate a solid return on invested capital for shareholders when the asset turnover ratio is high.

Companies with a high asset turnover ratio are more desirable and generally speaking their dividends are safer. Companies with high asset turnover ratios generally have higher return on invested capital.

Price to Earnings Ratio

One of the most popular valuation ratios investors use is the Price to Earnings ratio. The formula for calculating is very simple.

Price to Earnings ratio formula: Company Stock price / Earnings per share over 1 year period

Generally speaking companies that trade at Price to Earnings ratios of less than 20 are more reasonably priced.

Total Shareholder Return

While tempting to focus on only the dividend yield of a dividend paying stock, it is important to look at the total return on the investment.

Total Shareholder return measures both the stock price increase and any dividends paid. The total shareholder return is the measure investors should look at.

Total Shareholder Return formula: (Stock price increase + Dividend paid per share) / (Per share purchase price)

For example: You purchase Company Y at $100 a share. Company Y paid a $5 per share dividend in the year. At the end of the year company Y stock traded at $110 a share. The Total Share holder return is calculated as follows: Stock price increase = $110 - $100 = $10. $10 + $5 dividend per share = $15.

$15 / $100 = 15%. So the total shareholder return is 15%

Companies with a Total Shareholder return that outperforms the S&P 500 or DJIA are more desirable than companies where the Total Shareholder return is below the returns of the S&P 500 and/or DJIA.

Financial Ratio Summary

For dividend investing it is essential to analyze different companies using the financial ratios to identify high quality companies that pay safe, growing dividends.

These financial ratios help determine the underlying quality of the business and the safety of the company’s dividend.

Other important aspects to examine are debt levels, recession performance of the company, near-term business trends, industry factors and trends, and comparison of the company to other companies in the industry.

Final Thoughts on Dividend Investing

Understanding and using financial ratios to assess dividend paying investments is important. Identifying high quality businesses where the dividend payout is safe and growing will provide a margin of safety for your investment.

Dividend investing is a worthwhile long term investing strategy especially if you reinvest the dividends. The compounding effect of the dividend reinvestment will generate a decent stream of cash flow after several years.

To be a successful dividend investor it is important to take the time to assess different investment opportunities using at least the above financial ratios. There are many other financial ratios to consider so determine any others that are important and get as complete of a profile of the business before investing. This will help to ensure that you sidestep all the avoidable mistakes when investing.

To learn more about stock investing check out the "Beginner's Guide to Stock (Equity) Investing" post.

Sunday, March 6, 2022

Beginner’s Guide to Stock (Equity) Investing

Beginner's Guide to Stock Investing

Over the last century the stock market return is about 10% per year.

Returns in any year may be far below or above the average. It is important to have a long term time horizon for stock investments where you will not need the money for 3 to 5 years since there is greater risk when investing in equity (stocks).

This beginner's guide to stock investing will help you to understand the basic steps of fundamental stock analysis.

Benchmarks

It is important to be aware of the applicable investment benchmark for your stock as an investor. All types of investment asset classes have benchmarks. A benchmark is an index created to include multiple securities to represent some aspect of the total market.

Equity - The 2 most popular benchmarks in the equity market are the S&P 500 and the Dow Jones Industrial Average.

Fixed income (bonds and bond funds) – Top benchmarks for fixed income assets include Barclays Capital U.S. Treasury Bond Index, Barclays Capital U.S. Corporate High Yield Bond Index, and Barclays Capital U.S. Aggregate Bond Index

It is important to compare any investment against the appropriate benchmark for that investment asset class.

Stock Analysis

Before buying a stock, bond, or other investment vehicle it is important to analyze the investment and to get as complete of an understanding of the financial health, prospects, and trends of the investment as possible.

There are 2 theories of stock analysis: Fundamental stock analysis and technical stock analysis. This article focuses on the former (fundamental stock analysis) and provides the basic steps of fundamental stock analysis.

Fundamental Stock Analysis Steps

There are 4 primary steps to analyze an equity (stock) investment.

Gather information about the Company – Grab the Company financial reports, financial ratios from investment sites such as Yahoo Finance, and any relevant financial data you can find about the company
Review the Company's Financial Metrics & Data - Understand the company’s financial reports, data, and prospects
Understand the Company - Strengths, business model, management, etc.
Determine Best Investment Opportunity - Get as complete a profile of the company as possible and compare to find the best investment opportunity

1. Gather Information about the Company

You will want to start by understanding the company’s financials and the fundamentals of the company.

Review the latest annual report (Form 10-K) for the company.
Review the company’s balance sheet, income statement, and the statement of cash flows.
Read the company quarterly report (Form 10-Q) which reviews the quarterly operational and financial results.
Research financial data on the company through investment or brokerage websites such as Yahoo! Finance or Vanguard.com.

Once you have gathered the financial reports and data move on to Step 2.

2. Review the Company's Financial Metrics & Data

Focus on the following information and metrics in the financial reports and data. This will allow you to understand the inner financial workings and health of the company.

Note and references to ttm you find means trailing twelve months.

Return on Equity – this is how much profit a company generates with each shareholder dollar invested in percentage terms. Calculated by dividing the company’s annual net income by shareholder equity. This is a measure of how efficient a company is at generating profits.

Return on Assets – shows the percentage of the company’s profits generated with each dollar of assets. It is calculated by dividing the company’s annual net income by total assets. Again this is a measure of how efficient the company is at generating profits.

Beware that a company can artificially inflate return on equity by buying back shares to reduce shareholder equity and likewise can inflate return on assets by taking on more debt to increase the amount of assets.

Price-earnings ratio (P/E) – The P/E tells you how much investors are willing to pay to receive $1 of the company’s current earnings. The company’s trailing P/E ratio is calculated by dividing a company’s current stock price by its earnings per share (over the last 12 months). The forward P/E is calculated by dividing the stock price by the Analyst’s forecasted earnings.

Revenue – Revenue can be itemized into “operating” and “non-operating” revenue. It is the amount of money a company received during the specified reporting period and is referred to as the “top line”.

Operating revenue is generated from the company’s core business so that is the most important revenue.

Non-operating revenue usually comes from a one-time event such as selling an asset.

Net-Income (Earnings) – This is the total amount of money a company made after operating expenses, taxes, and depreciation are subtracted from revenue. This is referred to as the “bottom-line”.

Earnings per share (EPS) – Earnings (net income) divided by the total # of shares available to trade. This shows a company’s profitability on a per-share basis.

Earnings are not a perfect financial measure since it doesn’t tell you how efficiently the company uses its capital.

There are several balance sheet metrics that are good to look, also, such as long-term debt to equity. Cash on hand versus short term debt.

Additional financial metrics and ratios exist to get a good understanding of the inner financial workings of a company. The ones listed are the basic ones to start with. And as you mature as an investor you will likely look at other metrics such as Operating margin, the Quick ratio, Dividend yield, PEG ratio, etc.

3. Understand the Company - strengths, business model, etc.

The fundamental analysis and data in step 2 helps to understand the financial profile of the company but it doesn’t tell you the basics of the business and the industry characteristics the business operates in. It is important to understand the advantages and disadvantages of the business, the management experience, and the strategy of the company.

Likewise, before you invest your hard earned dollars in a stock, it is important to understand the company’s operations and prospects within the industry.

When purchasing a stock you are investing a personal stake in the business so you want to make sure the company’s prospects are good in the industry and that you understand the business operations.

Here are some characteristics of the business to understand:

Is management experienced and are they good stewards of the business? – What is the experience level of the management team? How diverse is the company’s board? Are there independent thinkers on the board? Investigate the management teams thinking and views by reading the annual reports and listening in or reviewing the company manuscripts to understand the strategy and how management speaks about the company prospects and/or challenges.

What could potentially go wrong? What fundamental changes could affect the business’s ability to grow over many years? Look for potential red flags by doing what if scenarios. Possible red flags could be a new leader is taking the business into a new uncharted territory, lawsuits pending against the company, issues with the core business or products, new technology that could obsolete the company’s products or services.

Does the company have a competitive advantage? Does the business have a unique position within the industry? Is the business difficult to compete against – huge start up costs, etc.

Competitive advantages include – business model, patent ownership, operational excellence, high switching costs, power in the industry, distribution channels, brand recognition.

What is the business model or how does the company make money? Invest in companies you truly understand. Understand how the business makes money. Is it clear how the company makes money and what their business model is? Is the business model something you understand?

4. Determine the Best Investment Opportunity

To pick the best investment opportunity for you it is important to make a decision based on the most complete picture you can. That is why it is important to review and understand all the information you have gathered in steps 1, 2, and 3.

Putting together a well-informed profile of the company including the advantages and disadvantages, how it compares in the industry, and any unique characteristics of the business will allow you to determine the best investment opportunity.

It is important to take a look at historical data for the company.

Does the company have a trend of rising revenue and profitability?
How does the company perform during tough economic periods?
How resilient is the company’s balance sheet?

It is important to look for companies with a track record of delivering shareholder value over time and that have a history of improving performance and profitability.

Likewise, it is important to compare how the company performs against industry benchmarks and how it compares to the same or similar businesses.

Once you have completed all four steps and you have as complete a picture as you can get on the company, it is time to decide if this company is a good investment. If not, continue to analyze other potential stocks using these four (4) steps to determine the best potential stock for your investment portfolio.

Beginner's Guide to Stock Summary

It is key to understand as complete of a picture as you can about an investment before buying.

There are four (4) important steps to analyze a company.

First you will want to gather financial data and reports for the company such as annual and quarterly reports. Second, you will want to look at important financial measures for the business such as revenue, net income, return on equity, etc. to understand the financial heath and trends of the company. Next, you will want to understand unique advantages and disadvantages of the company such as how good is the management team, does the business have a unique competitive advantage, what is the business model, and what could go wrong. Finally, you will want to compile as complete of a profile for the business as possible, what are the historical trends for the business, how does the business compare against industry averages and similar businesses in the industry, how resilient is the balance sheet during tough economic conditions, etc.

This will enable you to determine the best investment opportunity for your portfolio.

To learn more about investing check out these recent posts:

Dream Big - Travel & Life

Directory

Search This Blog