Best Dividend Stocks

When it comes to finding the best dividend stocks, you’ll probably want to use an automated stock dividend screener as a tool to find good candidates to buy.  Screening is a way to scan the stock market for stocks that meet your particular criteria.  Dividend investing can be very profitable, and while there are many stock screening programs out there (some you pay for, some are free – I’ll list a couple of free ones at the end of this article), it is important to understand the characteristics of good dividend stocks, so your screening tool can help you filter out unacceptable choices.

For an easy dividend stock screener to find the best dividend stocks, I would suggest focusing on the following qualities to help find strong dividend stock candidates:

Dividend Yield – The dividend yield can be calculated primarily in one of two ways – either by using the trailing 12 months dividends, or by using the expected dividends for the upcoming 12 months, and then dividing that number by the current price of the stock.  Ideally you want to buy dividend stocks that have a yield that is higher than the overall market.  Stock market yields as well as individual stocks yields will fluctuate over time, as stock prices move up and down, and the amount companies pay out in dividends changes, so it is good to check these factors right before you buy a stock, and not just rely on data you put together at some earlier point in time. At this time, I would suggest looking for stocks with dividend yields of at least 4% to 5%.

Profit – Also known as earnings, profit drives company growth, and more importantly for us, profit is what pays dividends in healthy stocks that pay dividends (some company’s pay for dividends by taking on more debt, and distributing that cash to share holders – see the next paragraph for more on debt).  While there are many ways to measure profitability, one widely used indicator that can be found on most stock screens is return on equity (ROE).  For ROE, the higher the better.  The minimum ROE we want is in the 10% to 12% range.  Another great indicator for profitability that is available on many stock screeners is earnings per share (EPS) – again, the higher the better for this indicator too.

Debt – Many of the best dividend stocks are from companies that are large, mature, and have accumulated long term debt during the process of growing into their current state.  The problem with debt is that too much of it can represent a risk to future dividend payments if the company goes into a rough patch, and earnings drop to the point where they may need the money they normally pay out as dividends to service their debt payments.  One easy way to measure debt is to look at the debt to equity ratio.  For our purposes, we would like to see the company financed with more equity than debt, which means that our dividend stock screener would need to limit the debt to equity ratio to less than .5, and ideally, you should look for stocks with a ratio even lower than that.

Market Cap – Also known as the market capitalization of a company, is a good way to filter the size of the company you are looking for.  Market cap is just the total number of shares outstanding, multiplied by the current price of the stock.  Most analysts use this as the measure of a company’s size.  For our dividend investing purposes, we want strong stable companies, and bigger companies are generally safer than smaller ones, so for market cap, select stocks that are at least $2 Billion. 

Valuation – This is how much the market is paying for a company’s earnings stream.  For this, we actually want a low valuation, because that usually means that a company’s stock price has been beaten down relative to it’s earnings.  The price to earnings ratio (P/E) is a widely available indicator that can help you assess valuation on a free dividend stock screener.

A couple of free dividend stock screeners that you can try to help you find the best dividend stocks are at MSN.COM and FINVIZ.COM.

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Stocks That Pay Dividends

Stocks that pay dividends can be a good alternative for investors either seeking regular income from their investment portfolio, or more consistent returns from their stock investments.  An investment in stocks that produce consistent dividends can be an ongoing source of profits for your portfolio.  These are some of the characteristics that these income producing investments provide:

1. Stocks that pay dividends can represent a single company, or they can be many companies under the organizational structure of a holding company, trust, closed end mutual fund, ETF, etc.  It is important to note that a majority of companies do not qualify for dividend investing for the simple reason that they do not pay dividends.
2. Companies that pay dividends do so because their management teams and boards of directors make a conscious, regular, and most importantly – discretionary – decision to pay their shareholders a dividend.  While most companies do this quarterly, there are many stocks that pay monthly dividends.
3. Dividend stocks typically have policies in place that promote the ongoing payment of dividends.  So while the decision to pay a dividend is at the discretion of the management team and board of directors, they typically have a goal of managing the company in a way that preserves, protects, and in many cases, grows the dividend income streams for their shareholders over time.
4. In many cases, stocks that pay dividends represent companies that are large, and more established (i.e. they have been around for a while).  These companies have created consistent, stable cash flows with very predictable earnings.  For example, utilities are a great type of stock that pays a dividend, they have a steady, predictable, source of income, expenses that are understood (and that can usually be passed along to their customers if expenses go up unexpectedly), which leads to a stable source of profits to pay dividends with.
5. Stocks in general are volatile, but stocks that pay dividends are usually lower in volatility than the overall stock market.  This is because investors are confident enough in the earnings of these companies, and the income they produce on a regular basis for their shareholders, that they reward this stability with lower price volatility, due to the justified view that these stocks are safer than average.
6. There are also tax advantages to owning dividend paying stocks.  Capital gains only trigger a taxable event when these stocks are sold, just like regular stocks.  The key tax advantage is that right now, the maximum federal income tax rate for dividends is only 15%.  This tax rate is lower than the tax rate you pay on bond interest, which is usually taxed at the same rate as your salary.  15% is typically much lower than your marginal tax rate for other sources of income.

As you can see, stocks that pay dividends have characteristics that set them apart from the overall stock market.  These income producing stocks may have a place in your investment portfolio.

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ROIC – What is Return On Invested Capital?

What is return on invested capital?   

Most casual investors have probably never heard of the acronym ROIC.  Investors that do their homework before they buy a stock have probably run across ROIC, but don’t really understand what it is, or why it is important.  So, what is return on invested capital?  At a high level, ROIC is a way to measure how efficiently it uses the cash it invests in it’s operations – whether that cash comes from loans or cash it generates from its ongoing operations.  Another way looking at ROIC is the amount of profit that a business generates for every dollar invested in it’s ongoing operations.

Before we get into too much detail, here is how to calculate ROIC (return on invested capital):

Net Operating Profit After Tax
——————————————————
Invested Capital (Long Term Debt + Equity)

When trying to answer the question “what is return on invested capital?”, or “why is ROIC better than ROE?”, there are a couple of details that an investor must master.  First, unlike return on equity, return on invested capital looks at all funding sources that a company’s management team uses to fund the growth of the business.  This includes both equity investments from shareholders, as well as debt investments from bondholders and banks.  ROE only uses shareholder equity as the denominator in the equation, which leaves out long term interest bearing debt used to finance the growth of the company.

The other detail that an investor needs to get used to is not just looking at net profit, which is used in the ROE calculation that they are probably accustomed to seeing, but instead looking at net operating profit after taxes (NOPAT) instead.  The difference in these two numbers is that net profit includes income from all sources, whereas NOPAT looks at income from sales revenue.  Some of the income items that are not included with NOPAT are interest on investments (typically interest that accrues on cash and cash equivalents), revenue from sub-leased office space, etc.  In other words, NOPAT focuses on revenue generated only from the main focus of the business activities of the company you are looking at.

By focusing on after tax net operating profit, and ALL of the capital that a business is using to sustain and grow that cash flow, the time it takes to learn what is return on invested capital can give an investor a much better and deeper view on the health of a company that is being considered as an investment candidate.

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Stocks That Pay Monthly Dividends

While you have probably heard about stocks that pay dividends every quarter, did you know that there are many stocks that pay monthly dividends?  When many income investors think about investing for dividends, they naturally look at safe, stable companies like McDonald’s(MCD), Proctor & Gamble(PG), and IBM (IBM), which have a long history of paying quarterly dividends.  These types of dividend stocks are usually financially stable, have a lot of liquidity so they are easy to buy and sell, and have enough income and cash reserves to cover their dividend payouts to investors every three months.

There are a couple of issues that investors in these type of quarterly dividend stocks should consider.  First, the investors income stream is exposed to a single company for each stock that they own, and second, depending on the mix of stocks in the investors portfolio, the dividend income can be very lumpy (i.e. most of the dividend money arrives in one month of the quarter, leaving the remaining two months with very little cash coming in.

Stocks that pay monthly dividends are an alternative that can provide regular, consistent, income to investors, and overcome the two main issues highlighted above.

First, monthly dividend stocks are typically traded on regular stock exchanges, and have enough liquidity for investors to easily buy and sell them.  Stocks that pay monthly dividends are usually trusts, closed end mutual funds, and other investment vehicles that actually own a portfolio of income producing assets.  This benefits investors because they get the diversification of the underlying portfolio owned by these companies, so investors are not as exposed to single company risk as they would be if they owned a single company that paid a quarterly dividend.

Second, since the income stream from stocks that pay monthly dividends comes three times as often as the cash flow from their quarterly brethren, the income is not going to be as lumpy.  This is a significant benefit for investors that need regular income, like retirees that need a passive source of retirement income to meet their monthly needs. 

One of the obvious items that investors considering purchasing stocks that pay monthly dividends over a company that pays a quarterly dividend is understanding the assets that are held by the monthly dividend company.  While this adds an extra research item, it is very easy to find this information in the standard government filings that publicly traded companies have to file with the SEC.

Stocks that pay monthly dividends are a great tool for people looking for consistent regular income.  Since these stocks may be new to you, just click on this link for a list of monthly dividend stocks.

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Stock Market Breadth

The definition of stock market breadth is the number of stocks participating in an overall stock market index price move, whether the stock price is moving up or down.  Market breadth is useful in determining the strength of a stock market trend.  The theory is that the more stocks participating in stock market trends, the stronger the price trend.  Many analysts have noted that a divergence between the price of stock market indices like the S&P 500, and the breadth of stocks participating in the trend can lead to a price trend reversal.  Using market breadth indicators may give you an edge in stock market timing, giving you an advanced view of when to tighten your trailing stop loss orders.

Market Breadth Indicators

Market breadth indicators come in a variety of forms, and they all have the intent of measuring the underlying stock participation in a rally or sell-off.  Most popular breadth indicators can be roughly divided into three categories:

1) Indicators based on stocks making new highs or new lows

2) Indicators based on stocks above or below a moving average

3) Indicators based on stocks that are advancing or declining in price

There are other market breadth stock market indicators, some, like the McClellan Oscillator, are a combination of those just mentioned, while others are based on an aggregate view of stocks exhibiting a particular technical indicator trait (for example the number of stocks in an index with an RSI value >= 90).

Stock market breadth indicators have been classified as technical analysis of stock market trends, as they do rely on the price action of individual stocks.  They are also sometimes referred to as stock market internal indicators.

Understanding the stock market is all about knowing which side of the trade you should be on (long or short), and this easier when you start with a top down analysis, which should include a study, and ongoing review, of stock market trends and their underlying strength using market breadth as a guide.

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Highest Dividend Stocks

Income investors looking for a good return on their investment often look for the highest dividend stocks, or more precisely, the highest yielding dividend stocks.  This can also be a good place for value investors to look for potential buy candidates because high dividend yields can be caused by a stock price being temporarily low (i.e. undervalued stocks), which simultaneously raises the yield.  However, the highest dividend stocks can also be a dangerous place to find buy candidates.

Normally when income investors are looking for dividends stocks, they are looking at monthly dividend stocks or stocks that pay dividends quarterly with the highest yield (adjusted for risk).  The issue with the highest dividend stocks on the top dividend stock list is that they are usually amongst the most risky stocks a conservative income investor will look at.  Many of these stocks have high dividend yields because the underlying stock price has fallen, while the dividend payment is presumably staying the same, giving the appearance of a high yield.  Stocks with high dividends should raise a flag with any income investor to be extra diligent doing their homework.  The biggest question you’ll need to ask yourself is whether or not the dividend is safe?

The first thing an income investor should screen for in stocks paying dividends is whether or not the stock is consistently profitable.  As they say on Wall Street, profits drive dividends, and many times, stocks with high dividends are also losing money – their dividends place them on the highest dividend stocks list because of the additional risk.

Another attribute that you should look for in profitable top dividend stocks is how well their earnings cover their dividends – also known as the dividend payout ratio.  Ideally, you want to see a stock paying out less than 50% of it’s earnings as dividends.  If the high dividend stocks you are looking at have a dividend payout ratio of 50% or less, the dividend has a higher probability of being safe – in other words it is less likely to be reduced or cancelled.

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List of Monthly Dividend Stocks

A list of monthly dividend stocks is sometimes hard to find, so I’ve compiled a list of stocks with monthly dividends here.  Monthly dividend stocks can be useful for people who are trying to smooth out the dividend income from there investments over all of the months in a quarter.  This helps counter the affect of having a lot of dividend paying stocks that pay quarterly dividends in one particular month of a quarter, leaving the rest of the months in the quarter without much dividend income.  Here is the list of monthly dividend stocks that I’ve found so far, if you know of others, please email me, so I can add them to the list for everybody to see.

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Monthly Dividend Stocks

Monthly dividend stocks can be a good idea for income investors to create a steady income stream.  If you are looking for regular income, you may want to consider monthly dividend stocks.  Thats right, there are stocks that pay monthly dividends.  These monthly dividend stocks are just like their quarterly dividend stock brethren, but they pay out their dividends – you guessed it – on a monthly basis.

Many people interested in income investing have stocks that pay quarterly dividends in their portfolio, as these are the most common type of dividend paying stocks.  Depending on the dividend payment dates, this can lead to inconsistent monthly income – for example you get a lot of dividend income in the first month of the quarter, and very little dividend income in the last month of the quarter.  One way to smooth this out is to buy stocks that issue dividends in different months of the quarter.  Another way to set up a more steady income stream is to put monthly dividend stocks in your portfolio.

Most stocks that pay monthly dividends are investment trusts, closed end funds,  or holding companies that own many income producing securities, that issue the income from these investments in the form of  a monthly dividend.  The list of monthly dividend stocks is nearly 300 long.

Adding stocks with a monthly dividend payment can help smooth out the monthly income in your portfolio.  Click on the link above for a list of monthly dividend stocks.

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How to Calculate Return on Invested Capital (ROIC) – Why use NOPAT?

Return on invested capital (ROIC) is usually calculated with Net Operating Profit After Taxes (NOPAT) instead of just corporate profits more commonly measured as Net Income (NI).  What about NOPAT makes it a superior indicator of corporate profitability vs. net income?

NOPAT Definition

NOPAT (Net Operating Profit After Taxes) is the profit that a company realizes from ongoing profit generating operations of the company.  For example, a stereo store will count earnings from selling stereos using NOPAT, but will not count income from leasing out extra space in it’s stereo store building as an office to another business, as that is not a part of it’s primary business activity.  This is different than net income, which counts all income a company generates, even if it is not generated from it’s primary business activity.

How to calculate NOPAT

Here is how to calculate NOPAT:

Net Sales – Operating Expenses = Operating Profit (Also known as EBIT or Profit from Operations)
EBIT – Taxes = NOPAT

A good thing about NOPAT is that it starts with net sales instead of net income, which eliminates income and expenses that are not associated with the main profit making operations of a company.  This eliminates items like interest expense and interest income. 

By focusing on profits (earnings) that are generated from the ongoing operations of a company, instead of the overall net income of a company, which contains GAAP related items that create financial noise, a clearer picture will emerge to help you find companies that are growing and may make good investments.

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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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What is Return On Equity?

Return on equity is a popular fundamental analysis technique to measure how efficiently a company uses it’s shareholders’ investment to produce eanings.  The formula to calculate Return On Equity (ROE) is straightforward:

Return on Equity (ROE) = Net Income / Shareholder equity

Obviously this is a much simpler formula than how to calculate ROIC (return on invested capital).  Some investors would answer the “What is Return On Equity?” question by stating that return on equity is an easy and readily available way to compare different companies profitability.  A company with a high return on equity is more likely to be capable of generating cash organically (internally). For the most part, the higher a company’s return on equity compared to its industry, the better.  You need to look at ROE relative to the industry the company your evaluating is in, because not all high ROE companies make good investments.  For example, companies that require little very little assets, like consultants, will have high ROE’s relative to capital intensive companies.

So, hopefully this helped you understand what is return on equity.

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Value stock investing is an investment strategy that looks for stocks which are undervalued when compared to a value you calculate with various fundamental analysis indicators.  While the description may sound a little complicated, you will see that with a little practice, fundamental analysis for value stock investing is not as difficult as it sounds, in fact, with readily available online tools, finding good value stocks is easy.

First a little history – value stock investing was popularized by Benjamin Graham and David Dodd, and their 1934 book, Security Analysis, remains popular to this day – many bookstores still stock this one on their shelves.  Famous investors like Warren Buffet and Mario Gabelli have made fortunes using the value stock investing strategy to find under priced stocks to buy.

Value stock investors look for stocks with strong fundamental characteristics, such as business revenue growth, cash flow, earnings growth, book value, and cash flow.  All of these items, and more, are found on company’s quarterly and annual reports.  The key is finding stocks that sell at a bargain price vs. their underlying quality based on these fundamental metrics.  Value stock investors constantly seek out companies that are currently incorrectly valued (i.e. undervalued) by the stock market and therefore have the potential to increase in share price when the market corrects its error in valuation.  Some good value stocks pay higher dividend yields due to their lower price relative to the dividend that they pay (there are even monthly dividend stocks that fall inot this category).

Since value stocks are under priced, this means that they are out of favor with the market, which makes value stock investors contrarians by definition.  Buying value stocks can, at times, be tough psychologically, because in many cases, you are buying companies or industries that are receiving a lot of negative press.  Right now there are companies and industries that you can read about in the news, where nearly every article you read in the business press, or every story about them you watch on television, is very negative.  As I write this article in Spring, 2009, there is a recession in full swing, with banks, housing stocks, and REITs all being whacked the most by the business media.  These are the types of areas where value stock investors are prospecting for good companies with good fundamantal characteristics, that are having their stock prices dragged down with the rest of the companies in their industry.  A good tool for determining if a stock is undervalued is to look at it’s earnings yield.

With the tools, resources, and articles posted on this website, value stock investing will become another tool for you to use in your successful online investing activities.

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ROIC, or  Return On Invested Capital, is one of my favorite value investing indicators for trying to forecast the financial performance of a company’s stock.  If you think about earnings growth at a high level, most companies have to pay a price to achieve earnings growth – by issuing stock, selling long term bonds (debt), investing in assets, and/or investing in working capital.  ROIC is a superior way to measure this cost to achieve growth, and to compare one company’s financial performance to another company’s, or for that matter, to the performance of an industry group as a whole.  In a nutshell, ROIC is a way of determining the amount of cash earnings a company produces for every dollar invested, and is a primary tool for value investing, along with equity growth rate, earnings yield, and free cash flow growth.

You may already be familiar with one of the cousins of ROIC – Return on Equity (ROE).  ROE, which divides net income by the average shareholder equity over the time period being examined, is also a good measure of a company’s financial performance, and a favorite stock value indicator among value investors.  Click here if you want to learn more about what is Return On Equity.  The downside of ROE is that it does not take into account certain balance sheet liabilities that are being used to power a company’s growth, thus ROE may overstate the company’s economic efficiency.  ROIC corrects this issue, which is why I like it better than ROE.

ROIC is a good way to measure the quality of earnings growth, and is calculated with Net Operating Profit After Taxes (NOPAT) to focus on that earnings quality.  Lets use an example:  Company ABC sells a popular line of widgets, and earned $20 million last year.  This year, they decide to expand, and take on $20 billion in debt to finance that growth.  They are successful, and their earning double to $40 million.  Investors focusing on earnings growth are ecstatic – the company doubled it’s yearly earnings.  ROIC investors, however, are probably running for the exits, because they see that while the company doubled it’s earnings, the debt the company took on to finance that earnings growth only yielded a 1% return ($20 million divided by $20 billion), which is a very inefficient use of dollars invested in the company.  ROIC, unlike ROE or earnings growth, will highlight that inefficient use of dollars.  Investors looking for value stocks should look for high returns on invested dollars, as represented by ROIC, in addition to other key fundamental measures like business revenue growth.

Next up we will look at how to calculate ROIC.

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Value Stock Investing

Picking good value stocks will cause you to rely on a fundamental analysis of the company’s operating condition, as represented in its quarterly and annual reports.  Fundamental analysis is concerned with values found on balance sheets, income statements, and statements of cash flows.  Don’t let fundamental analysis scare you, the numbers needed for choosing good value stocks are freely available on the internet.  One really good website for getting fundamental data, including pertinent ratios for value investors, is msn.com.

Good value stock picking uses some of the important and popular fundamental analysis ratios shown below:

Return on Equity

Return on Equity is one of the most powerful value stock measures available – it compares a company’s profit to the total shareholder equity as represented on the company’s balance sheet.  This ratio shows how efficiently the company’s management is using the shareholders equity.  Always look for companies with above industry average return on equity.

Book Value per Share

Book value per share is calculated the ratio, which is calculated by subtracting a company’s total liabilities from its total assets and then dividing this book value by the total number of outstanding shares of stock. Deep value stocks trade at or below their book value.  One thing to keep in mind when looking at book value on major money websites is that book value can count intangible assets like goodwill, it’s usually best to remove intangible assets from the book value equation before calculating book value (also known as Tangible Book Value). Use equity growth rate calculated with BVPS to find good stocks to invest in.

Earnings per Share (EPS)

Earnings per share are calculated by dividing total profit after tax by total number of shares outstanding. EPS can be found on most major financial websites.  For value investors looking for deep value stocks, you would ideally like to find a stock that has a consistent historical earnings growth rate.  A value stock may have a currently low price not because of an earnings miss, but maybe just an analyst downgrade, unfavorable news report, etc.  The important things to look for are consistently growing earnings both from quarter to quarter, as well as compared to the year ago quarter.  Read our article on Net Operating Profit After Taxes (NOPAT) for an alternate way to calculate earnings.

Price to Earning (P/E) ratio

Price to Earnings ratio is just what it looks like – divide a stocks price per share by it’s earnings per share, and you have the P/E ratio.  This number is also known as the earnings multiple of a stock.  When looking for a good value stock, we need the price (P) to be relatively low compared to the earnings per share (E).  “Relatively low” means you need to compare the stock you are considering relative to other stocks in the same industry, with similar earnings and sales growth rates.

Dividend Yield

A stocks dividend yield is important to value investors.  There are many studies that show at least half of the long term return you can expect from the stock market comes from dividends.  Calculate the dividend yield by dividing the annual dividend payout by the price of the stock.  Since value stocks are out of favor and low priced, you would expect a higher percentage dividend yield on a value stock. One thing to watch for on high dividend yield stocks is the percentage of quarterly earnings it takes to cover the dividend payout.  Value stocks as a group have generally hit a rough patch, so their earnings may be temporarily low, however, you really want to make sure that if/when your stock returns to a more favorable earnings climate, it will need no more than half of its quarterly earnings to cover dividend payouts.

Good value stock picking relies on a host of other fundamental indicators, and we will explore more of those in upcoming articles.  Additionally, using stock market breadth to help determine when the market is right to invest in is also critical in making the right investment decisions.  It is a compination of finding the right stock, and buying it at the right price, that tilts the odds of a successful investment in your favor.

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