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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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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