Dividend Investing

Dividend investing is for people seeking income from their investments, who are also willing to take on a little more market risk than bonds offer in order to try to achieve growth in both their principal and the dividend income provided by their dividend stocks, not just by chasing the highest dividend stocks.  A successful dividend investor knows that this strategy can help them stay ahead of inflation.

One of the first steps in dividend investing is identifying companies that are in a position to not only maintain the dividend that they are paying out to their dividend investor base, but can also as a dividend growth stock opportunity.  A good way to determine if a stock fits this criteria is to look at it’s dividend payout ratio.

Dividend Payout Ratio

The dividend payout ratio can be calculated in a number of ways, so we’ll look at two of them and let you decide which one to use for your dividend investing screens (my favorite dividend payout ratio calculation is the second one).

The most popular way is calculated by dividing the annual dividend a company pays out per share by it’s annual earnings per share.

Dividend Payout Ratio = Annual Dividend Per Share / Annual Earnings Per Share

These numbers are readily available at most popular financial web sites, and can be included in dividend investing screens at sites like MSN Money.  Using this version of dividend payout ratio calculation, a level of 50% or lower is considered good.  So, this calculation is pretty easy, and the data is readily available, but for good dividend investing principals, it has a flaw…

The problem with the above calculation is that EPS has some noise embedded in it that can mis-lead a dividend investor into buying a company that is not a dividend growth stock candidate.  In my view, good dividend investing stocks’ dividends need to be paid out of the ongoing cash operating profits a company generates, and due to  GAAP accounting rules, EPS contains more than this.  For dividend investing, it is better to use annual free cash flow (FCF) instead of EPS in the dividend payout ratio calculation.

Since free cash flow takes into account both expenses and capital outlays, it shows how much cash is left over from company operations to apply to dividend payouts.  With the inherent noise in EPS taken out of the dividend payout ratio calculation, a level of 60% – 65% or lower can be considered good for dividend investing (obviously lower is better in either method of calculating dividend payout ratio).

Dividend investing can be a profitable endeavor when you use the right tools.  If you’re a dividend investor, please leave a comment on how you screen for good dividend stocks.

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Earnings Yield is a very popular, and useful, tool for investors who try to beat the market with value stocks investing. 

Earnings Yield

Earnings yield can help value stocks investors in their quest to find good solid companies that are currently relatively cheap.  Using indicators like return on invested capital (learn how to calculate ROIC), can be helpful in finding a list solid companies, and once you’ve identified this list, earnings yield can help you determine if the company is cheap enough to buy right now, after all, that is what value stock investing is all about.  Earnings yield does this by dividing a company’s annual earnings per share (you can use a trailing 4 quarters view of EPS for this if you’d like) by the company’s current market price per share.  This number is expressed as a percentage, which makes it easy to compare with bond yields.

How to Calculate Earnings Yield

There are a couple of ways to calculate earnings yield.  Since you don’t find this number in a lot of free online stock screeners, I’ll cover both methods, and you can decide which one you want to use. 

The first way to calculate earnings yield is to take the inverse (1/x) of the P/E ratio.  Since P/E ratios can be found in most financial publications, web sites, and stock screening tools, it is very easy to find this number, and invert it on a calculator or in a spreadsheet, to give you the earnings yield.  This method is very simple to use, and gives you a quick view of how cheap (or expensive) a stock is.

The other way to calculate earnings yield is a little more involved, but gives you a better understanding of how a company is valued relative to it’s earnings.  This form of earnings yield was written about by Joel Greenblatt in his book, “The Little Book That Beats the Market”.  The earnings yield he created is useful in comparing companies with different tax rates and levels of debt.  Greenblatt’s earnings yield formula is:

Earnings yield = pre-tax operating profit (EBIT) / Enterprise Value

So, in this case, the numerator (EBIT) comes from the income statement, and the denominator (Enterprise Value) is calculated by adding the market value of all equity – both common and preferred – to the value of all interest bearing debt that the company owes.  The value of equity is just the shares outstanding multiplied by the price of the stock, and interest bearing debt can be found on the company’s balance sheet.

I like Greenblatt’s method of calculating earnings yield better than the more popular E/P method, since it gives a more accurate view of what is happening inside of a company, and also gives a more balanced view when comparing multiple companies to each other.

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Free Cash Flow

Free cash flow (FCF) is the left over cash a company has after paying for it’s growth and ongoing operations.  Free cash flow growth is another one of our primary indicators used for value stock picking, as it helps us gauge the relative health of a company.  The good thing about free cash flow is that it accounts for outlays of both expenses as well as capital asset purchases. 

How to calculate free cash flow

Learning how to calculate free cash flow is simple, and you can make it even more powerful when you use it together with other powerful value stock picking metrics, once you learn how to calculate ROIC and equity growth.  Free cash flow is calculated by subtracting capital expenditures from operating cash flow:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Operating cash flow is Net Income + Amortization/Depreciation – Changes in Working Capital

So the full Free Cash Flow formula looks like this:

Net Income + Depreciation/Amortization – Changes in Working Capital – Capital Expenditures
= Free Cash Flow

You can find the numbers for calculating free cash flow on annual or quarterly earnings statements for any public company you are examining.  Net Income and Depraciation/Amortization are on the income statement, working capital and capital expenditures are on the Cash Flow Statement (or Statement of Cash Flows).

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Equity Growth Rate

Equity growth rate for any company is also known as the book value growth rate.  Equity is what is left over when liabilities are subtracted from assets on a company’s balance sheet.  Equity represents what is left over if a company is liquidated and ceases to exist.  The equity growth rate is the percentage that equity per outstanding share of stock (or book value per share) has grown over the last year.  Equity grows when a business accumulates surplus profits.  Think about it – many profitable businesses have to use their earnings to fund their growth, either by building new stores, replacing old or worn out capital equipment, etc.  Businesses that accumulate excess profits while still growing are special indeed!  We use equity growth rate to find these great businesses.

How to Calculate Equity Growth Rate

Learning how to calculate equity growth rate is a great companion for the other skill you learned for finding great investments when you learned how to calculate ROIC.  Equity growth rate is calculated by dividing this years book value per share by last years book value per share, the subtracting 1:

Equity Growth Rate = BVPS(today)/BVPS(last year) – 1

Equity growth rate is represented as a percentage.  Make sure you adjust for dividend distributions (if any) to get an accurate view of equity growth rate.

What to look for in equity growth rate

Consistent equity growth of greater than 10% over 5 to 10 years is what a great company should have.  If you see some anomallies in the historical equity growth rates, take the time to understand why those divergences from the trend occurred (both up or down divergences).  Value investing looks for companies with good equity growth rates that may be temporarily under priced.  Comparing the equity growth rate between companies in the same industry is a good way to rate which ones should be considered as an investment.

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