We can make money in two primary ways from investing in shares of a company.
You buy shares at a certain price, and then over time those shares go up in price. When you sell the shares, you receive what are called capital gains, which are the difference between what you sold the shares for and what you originally paid for those shares. If I buy 1000 shares of a company at $20 per share, for $20,000 total, and then sell those shares 5 years later for $60 each, for $60,000 total, then I’ve made $40,000 in capital gains.
You buy shares, and then over time those shares continually pay stock dividends. A dividend is a payment, usually of cash, made to the stockholder at regular or irregular intervals.
In order to grow wealth through either capital gains, dividends, or both, we need to use certain stock metrics to help us determine whether the stock is a good value or not. If we’re interested in capital gains, we need to determine whether the company is growing earnings and is reasonably valued, so that the share price will increase in value over time. If we’re interested in dividends, we need to see how much the company is paying out in dividends, whether the dividend amount is growing over time, and whether the dividend is adequately supported by legitimate cash flow. As a dividend growth investor, I am interested in total overall returns on capital. I wish to purchase shares, reinvest dividends into buying more shares, and then either sell the shares a long time from now after each share has gone up in price considerably, or just keep hanging on to them and enjoying the larger and larger passive income stream. Keep in mind that a fantastic company can make a horrible stock choice if its overvalued.
I wrote an article about how to invest in the stock market, which covers the earliest basics. This article is a follow-up to that, and elaborates on that and begins to describe various stock metrics to look at when considering to purchase an investment.
Earnings per Share (EPS)
Each year, a company (hopefully) makes a profit. The earnings per share (EPS) is equal to the total company net earnings (for a single year, the most current year) divided by the number of shares. Each share is a miniature version of the business. If a company makes $1 million in profit in a given year, and it consists of 100 shares, then EPS is equal to $10,000.
Price to Earnings Ratio (P/E)
This is generally looked upon as the bread and butter of stock metrics. It’s a valuable tool, but make sure you use it wisely. The price to earnings ratio (P/E) is the price of the stock divided by the earnings per share. This is important because it tells you how much people are willing to pay for each dollar of earnings, and helps you assess whether the shares are currently overvalued or not.
As an example, lets say I have a gym. If my gym makes $100,000 annually in net profit, and someone is willing to pay $1,000,000 for it, then they are paying a P/E of 10. If another person offers me $1,200,000, then they are paying a P/E of 12. As a stock example, if a company currently has a share price of $80, and EPS this year is $8, then the P/E ratio is 10. All other things being equal, the lower the P/E the buyer pays the better, since they are paying less for the earnings. I’d much rather pay $1,000,000 than $1,200,000 for the same gym if I can.
A reasonable P/E will vary by industry and individual companies. In a slow growth company, one can expect a lower P/E. In a high growth, high quality company, a P/E might be over 30 and still be reasonable, because people are paying up front for the hopes of growth. In a cyclical company, like a manufacturing company, the P/E may vary from very low to very high depending on the state of the economy.
All things being equal, and with certain exceptions, it’s good to look for companies that have low P/E values. If two companies are identical, but one has a P/E of 10, and the other has a P/E of 15, then it’s like one is on sale and the other is not. If you’re going to buy good products, it’s best to find them on sale. If you’re going to buy good companies, it’s also best to buy them on sale.
P/E doesn’t tell the whole story, though. It doesn’t say how much debt a company has, or how much they are growing, whether they pay a dividend, or whether they are earning real cash or are just using accounting tactics to produce the illusion of profit. A P/E serves as a good first glance at a company, but then you need to dig deeper into other metrics. A company might have a low P/E, but if they have a lot of debt and aren’t growing, then it’s not a good value. Its on the discount rack for a reason.
A value investor looks for good companies that are on sale. This means that the company is undervalued; the stock price does not accurately reflect the high quality of the company.
Earnings Growth Rate
The earnings growth rate tells us how much the company has grown earnings over the past several years. The higher the better, because it shows that the company is healthy and growing and if this continues, shares are likely to appreciate in value. If a company earns $1 million in profit one year, and $1.1 million the next year, and $1.21 million the year after that, then the company is growing their earnings at a rate of 10%.
EPS stands for earnings per share. EPS growth rate is similar to the earnings growth rate, but companies also have the option to repurchase their own shares, therefore reducing the number of outstanding shares of the company. This means that the profit is broken up into a smaller number of shares, so the earnings per share increases. EPS growth takes this into account, unlike the earnings growth rate.
As an example, let’s assume we have a gym that consists of 10 shares:
On year 1, the gym made $1 million in company profit, and consisted of 10 shares. So, earnings per share (EPS) is $100,000. At the end of the year, the gym management makes a deal with one of the shareholders to purchase their share from them with some of the profit, and then cancel that share, so the gym is now only made up of 9 shares instead of 10. This makes the other 9 shareholders happy, because now they each own 11.11% of the company rather than only 10%.
On year 2, the gym managed to increase its company profit by 10% to $1.1 million, but now it only consists of 9 shares. So, EPS is now approximately $122,000. At the end of this year, management again convinces one of their shareholders to sell their share back to the company, and the company then cancels that share from existence. Now, the company only consists of 8 shares, and each shareholder now owns 12.5% of the gym company.
On year 3, the gym managed to increase its company profit to by another 10% to $1.21 million, but now it only consists of 8 shares. So, EPS is now approximately $151,000.
Consider that over these years, company-wide earnings grew by an average of 10% annually, from $1 million to $1.21 million. Earnings per share (EPS), however, grew by an average of 23% annually, from $100,000 to $151,000. This is because the larger and larger company-wide earnings are divided into a smaller and smaller number of shares.
This metric tells you how much a single share pays out in dividends each year based on the most recent dividend. As you hold shares of a dividend-paying company, you’ll get paid passive dividend income on a quarterly basis (or whatever the company’s schedule is). For example, a share worth $50 might pay out $0.50 per quarter, and that equates to an annual dividend of $2. If one owns 1000 of these shares, then they’ll receive $2000 in dividends this year.
The dividend yield is the annual dividend per share divided by the current price of that share. This tells you how much of a return you’ll get per year from dividends. As an example, if shares of a company are trading at $50, and each share pays out a $2 dividend each year, then the dividend yield is 4% (2/50 = .04 = 4%). Dividend yields can range anywhere from 0% to upwards of 10%. A lot of dividend investors fall into the trap of chasing high yields, but you have to look at other metrics as well, because a high yield isn’t everything.
The earnings payout ratio is the annual dividends per share divided by the annual earnings per share. This metric is important because it tells you what percentage of earnings is being paid to shareholders. You want to check out this metric because if the payout ratio is too high, then it means that the company might not be able to sustain it’s own dividend, or may have very slow growth. Its also a good idea to check cash flow and free cash flow to ensure that the earnings are backed by real cash, but for now, earnings payout ratio is good enough.
For some examples, if a company makes $100,000 in net profit, and pays out $40,000 in dividends to shareholders (and reinvests the other $60,000 into growing the business), then the payout ratio is 40%. If a share of a company has earnings per share of $8, and pays out $4 in dividends per share annually, then the payout ratio is 50%.
Dividend Growth Rate
A dividend growth investor is interested not in just dividends, but growing dividends. The dividend growth rate tells you, on average, how much the dividend has grown each year. For example, if company XYZ pays $1.10 per share in dividends this year, and paid $1 in dividends last year, then the dividend increased 10% between those years. There are many companies out there that have increased their dividend each year for decades.
Dividend growth is surprisingly powerful. If you own 1000 shares of a company, and each share pays $1 in dividends this year, then your annual passive income from dividends is $1,000. If that company manages to grow dividends by 10% per year, then in 20 years your 1000 shares will be paying over $6,700 per year in annual passive dividend income. The growth will be even more astounding if you reinvest those dividends into buying more shares over the course of those 20 years, since each of your newly purchased shares will also pay dividends, allowing you to buy more and more shares.
LT Debt/Equity is a ratio between a company’s long term debt and their equity. Long term debt is how much debt the company currently carries that they are paying interest on over a long period. (This could be comparable to a person with a mortgage, car loan, or student loan.) Equity is the difference between company Assets and company Liabilities. If a company has $250,000 in assets (buildings, cars, cash, etc.) and $100,000 in total liabilities (debt, accounts payable, deferred taxes, etc.), then their total equity is $150,000. If they have $50,000 in long term debt (which is a part of their liabilities), then their LT Debt/Equity ratio is 0.333. The lower the number, the less leveraged the company is in debt. I prefer to buy low debt companies, since they are better at surviving when economic downturns occur, and have more options available to them when it comes to expanding their business. It also shows management prudence.
So in summary, when looking for a dividend growth company to invest in, it’s preferable to have a low P/E ratio, a low LT Debt/Equity ratio, a high earnings growth rate, a high dividend growth rate, and a moderate or high dividend yield but one that is adequately covered by earnings (moderate or low payout ratio). There are more metrics to consider, but this is a solid start.
8 Reasons to go with Dividends
Good basic stuff there. I think a good improvement of the LT debt/equity ratio would be to remove goodwill before the calculation.
One extreme case is Procter & Gamble. “normal” LT debt/equity is 0,7 which is pretty strong. But 90% of Procters Equity consists of goodwill. Without the goodwill the company has a LT debt/equity of 6,1 which is very weak.
Goodwill arises when a company buys another company for more then the accounting value (the equity). Most companies (naturally) sell for more then their book value. A company like P&G has bought companies like Wella and Gillette which of course boosts their goodwillpost. This makes it unfair to compare P&G directly with a company like Coca-Cola with only 16% goodwill in its equity. When you remove goodwillposts you get a fairer comparison. Do you agree?
I do agree to a certain extent. This is intended to be a fairly basic post (it defines things like “EPS” and “dividend yield”), so I kept various nuances out of it to not overwhelm the intended audience of this sort of post.
I wouldn’t discount goodwill completely. I look at it on a case-by-case basis, because if a company has a collection of strong brands like PG, they can indeed sell them for above the book value if chosen to and recoup some (but often not all) of their goodwill. PG has sold businesses to companies like Smuckers and Church and Dwight from time to time for respectable prices. More than half of PG’s goodwill was a result of the Gillette deal.
If a company continually overpays for companies that it buys, then the goodwill is very detrimental to the balance sheet. If the company buys seriously valuable brands that it is later able to sell at a decent price, then goodwill is not all that inaccurate. The difficulty is that goodwill is hard to judge, and management has a lot of control as to how much to impair their goodwill during the annual review.
I would suggest that PG has a moderately strong financial condition. They have a sizable amount of debt, but also a very high interest coverage ratio.
Good points there. Buying companies adds value above the accounting value. And P&G does have a strong interest coverage, above 10 if I recall correctly (KO has about the double).
I just feel like its unfair to compare companies with different levels of goodwill with each other. Coca-Cola may have been building up brand strength (for example developing a lot of new products) internally which doesnt show much on the balance sheet while P&G buys alot externally, thereby boosting their balance sheet.
P&G is a great company with enourmus brand values but it has little margin of failure in my view. Increasing the debt to these levels are not the conservative management im looking for.