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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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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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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