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"Even if you fall on your face, you're still moving forward."

Robert Gallagher

In the learning to fish series, we provide investors with suggested guidelines for choosing a potential candidate and one candidate is selected as our play of choice. We provide reasons for this choice and in doing so hope to impart some understanding to those who are new to the field of dividend investing. A lot of ratios will be used throughout this article, and it would be best for investors to get a handle on some of these ratios as they could prove to be very useful to the selection process. Some of the more important key ratios are listed below, but before we provide guidelines and details on some of the more important key ratios, we would like to start of by listing our play of choice.

Fresenius Medical Care AG & Co. (NYSE:FMS) is our favorite play on this list for the following reasons:

  • A strong levered free cash flow of 687 million.
  • Cash flow per share increased from $4.61 in 2009 to $5.42 in 2011.
  • Annual EPS before NRI has jumped from $2.43 in 2007 to $3.54 in 2011.
  • Net income increased from $965 million in 2009 to $1.17 billion in 2011.
  • EBITDA increased from $2.23 billion in 2009 to $2.7 billion in 2011.
  • Total cash flow from operating activities increased from $1.34 billion in 2009 to $1.45 billion in 2011.
  • A decent ROE of 13.07%.
  • A good quarterly earnings growth of 14.4%.
  • A five-year sales growth of 8.17%.
  • Decent current and quick ratios of 1.34 and 1.11 respectively.
  • A good interest coverage ratio of 6.08.
  • A very low payout ratio of 19% and five year average payout ratio of only 20%.
  • Cash And Cash Equivalents have increased from $301 million in 2009 to $457 in 2011.
  • Gross profit has increased from $3.8 billion in 2009 to $4.5 billion in 2011.
  • A five-year dividend growth rate of 11.06%.
  • A good three year total return of 87%.
  • $100K invested for 10 years would have grown to $551K.

We generally base our choice on the following factors:

Net income - It should be generally trending upwards for the past 3-4 years.

Total cash flow from operating activities - It should be trending upwards for the past 3-4 years.

Current ratio - Should be above 1

Interest coverage ratio - Any value above 1.5 is OK, but we would aim for 2.5-3.00 as our starting range. The higher the number the better.

Sales - They should generally be trending upwards for the past 3-4 years.

Levered free cash flow - This is the icing on the cake. If a company meets most of the above requirements and also has a positive levered free cash flow, it can generally be viewed as a good long term buy. Two examples are Leggett & Platt, Incorporated and Procter & Gamble Co.

The following criteria apply only two dividend paying stocks and not to growth stocks that might not pay out dividends:

Payout ratio - It should generally be below 100%, but a ratio below 70% is optimal. Payout ratios are not that important when it comes to MLPs/REITs as they generally pay a majority of their cash flow as distributions; in the case of REITs by law they have to pay out 90% of their cash flow as dividends. Payout ratios are calculated by dividing the dividend/distribution rate by the net income per share, and this is why the payout ratio for MLPs and REITs is often higher than 100%. The more important ratio to focus on is the cash flow per unit. If one focuses on the cash flow per unit, one will see that in most cases, it exceeds the distribution/dividend declared per unit/share.

Dividend growth rate - It should be at 5% or higher. A high yield with a low dividend growth rate is not good in the long run, but neither is a low dividend yield with a high growth rate. One needs to find an equilibrium here. And there are exceptions to this rule. Some stocks appreciate rather rapidly and so a low dividend could be offset by the capital gains.

Five year dividend average - We generally aim for stocks that have a yield of 4.5% or higher. There are exceptions to this rule. Some stocks appreciate very fast, so even though the yield might be low, one can more than make up the difference through capital gains. One example is Jarden Corp.

An early warning signal that the company could be in trouble is when the total cash flow generated from operating expenses is not enough to meet the dividend payments. This information can be gleaned by looking at the cash flow statement. This is readily available at Yahoo Finance. In the example below we used LEG and the data was obtained from Yahoo Finance.

The cash flow in this case was more than enough to easily cover all the dividend payments for all the above years. In this the time period was from 2008-2010.

Many traders use other metrics and that is fine. We are just trying to provide a guideline. As you get a better handle of the ratios explained below you can create your own list of criteria.

"Long-term debt-to-equity ratio" is the total long term debt divided by the total equity. The amount of long-term debt a company carries on its balance sheet is very important for it indicates the amount of money a company owes that it doesn't expect to pay off in the next year. A balance sheet that illustrates that long term debt has been decreasing for a few years is a sign that the company is doing well. When debt levels fall, and cash levels increase the balance sheet is said to be improving and vice versa. If a company has too much debt on its books, it could end up being overwhelmed with interest payments and risk having too little working capital which could in the worst case scenario lead to bankruptcy.

"Operating cash flow" is generally a better metric than earnings per share because a company can show positive net earnings and still not be able to properly service its debt. The cash flow is what pays the bills.

"The payout ratio" tells us what portion of the profit is being returned to investors. A payout ratio over 100% indicates that the company is paying out more money to shareholders then they are making. This situation cannot last forever. In general if the company has a high operating cash flow and access to capital markets, they can keep this going on for a while. As companies usually only pay the portion of the debt that is coming due and not the whole debt, this technique/trick can technically be employed to maintain the dividend for sometime. If the payout ratio continues to increase, the situation warrants close monitoring as this cannot last forever. If your tolerance for risk is a low, look for similar companies with the same or higher yields, but with lower payout ratios. Individuals searching for other ideas might find this article to be of interest - 5 Covered Calls: Atlas Pipeline Partners Is Best Of the breed.

"Current Ratio" is obtained by dividing the current assets by current liabilities. This ratio allows you to see if the company can pay its current debts without potentially jeopardizing future earnings. Ideally the company should have a ratio of 1 or higher.

"Price to free cash flow" is obtained by dividing the share price by free cash flow per share. Higher ratios are associated with more expensive companies and vice versa. Lower ratios are generally more attractive. If a company generated $400 million in cash flow and then spent $100 million in capital expenditures, then its free flow is $300 million. If the share price is $100 and the free cash flow per share are $5, then company trades at 20 times-free cash flow. This ratio is also useful because it can be used as a comparison to the average within the industry. This gives you an idea of how the company you are interested in holds up to the other companies within the industry.

"Interest coverage" is usually calculated by dividing the earnings before interest and taxes for a period of one year by the interest expenses for the same time period. This ratio informs you of a company's ability to make its interest payments on its outstanding debt. Lower interest coverage ratios indicate that there is a larger debt burden on the company and vice versa. For example if a company has an interest ratio of 11.8, this means that it covers interest expenses 11.8 times with operating profits.

"Price to tangible book" is obtained by dividing share price by tangible book value per share. The ratio gives investors some idea of whether they are paying too much for what would be left over if the company were to declare bankruptcy immediately. In general stocks that trade at higher price to tangible book value could leave investors facing a great percentage per share loss than those that trade at lower ratios. The price to tangible book value is theoretically the lowest possible price the stock would trade to. Additional key metrics are addressed in this article - 5 Covered Call Plays Ranging From Excellent To Run.

Fresenius Medical Care AG & Co

Industry: Diagnostic and Health Related Services

Levered Free Cash Flow: 684.74M

Growth

Net income for the past three years

Net Income 2009 = $965 million

Net Income 2010 = $1065 million

  1. Net Income 2011 = $1177 million
  1. EBITDA 12/2011 = $2692 million
  2. EBITDA 12/2010 = $2452 million
  3. EBITDA 12/2009 = $2234 million
  4. Net income Reported Quarterly = $226 million
  1. Total cash flow from operating activities
  2. 2009 = $1.34 billion
  3. 2010 = $1.37 billion
  4. 2011 = $1.45 billion
  1. Cash Flow 12/2011 = 5.42 $/share
  2. Cash Flow 12/2010 = 4.97 $/share
  3. Cash Flow 12/2009 = 4.61 $/share
  1. Annual EPS before NRI 12/2011 = 3.54
  2. Annual EPS before NRI 12/2010 = 3.25
  3. Annual EPS before NRI 12/2009 = 2.99
  4. Annual EPS before NRI 12/2008 = 2.79
  5. Annual EPS before NRI 12/2007 = 2.43

Performance

  1. ROE = 13.07%
  2. Return on Assets = 5.69%
  3. Quarterly Earnings Growth = 14.4%
  4. Quarterly Revenue Growth = 4.9%
  1. Price to Sales = 1.6
  2. Price to Book = 2.41
  3. Price to Tangible Book = -10.33
  4. Price to Cash Flow = 12.54
  5. Price to Free Cash Flow = -15.3
  6. Total return last 3 years = 87.18%
  7. Total return last 5 years = 53.75%

Dividend history and Sustainability

  1. Current Ratio 09/2011 = 1.34
  2. Current Ratio 5 Year Average = 1.39
  3. Quick Ratio = 1.11
  4. Cash Ratio = 0.45
  5. Interest Coverage 09/2011 = 6.08
  1. Payout Ratio 09/2011 = 0.19
  2. Payout Ratio 06/2011 = 0.19
  3. Payout Ratio 5 Year Average 09/2011 = 0.2
  4. Payout Ratio 5 Year Average 06/2011 = 0.2
  5. Change in Payout Ratio = -0.02
  1. Dividend yield 5 year average = 1.1%
  2. Dividend growth rate 3 year Average = 1.26%
  3. Dividend growth rate 5 year average = 11.06%
  4. Paying dividends since = 1998

Notes

It falls under the category of "excellent."

Company: Vimpelcom Ltd (VIP)

Levered Free Cash Flow = 1.86B

Basic Key ratios

Market Cap ($mil) = 18123

Growth

  1. Net Income ($mil) 12/2011 = 194
  2. Net Income ($mil) 12/2010 = 1721
  3. Net Income ($mil) 12/2009 = 1117
  4. 12 months Net Income this Quarterly/ 12months Net Income 4Q's ago = -67.9
  5. Quarterly Net Income this Quarterly/ same Quarter year ago = -183.72
  1. EBITDA ($mil) 12/2011 = 7663
  2. EBITDA ($mil) 12/2010 = 4946
  3. EBITDA ($mil) 12/2009 = 3845
  4. Net Income Reported Quarterlytr ($mil) = -386
  5. Annual Net Income this Yr/ Net Income last Yr = -88.74
  6. Cash Flow ($/share) 12/2011 = 3.82
  7. Cash Flow ($/share) 12/2010 = 3.66
  8. Cash Flow ($/share) 12/2009 = 2.71
  1. Sales ($mil) 12/2011 = 20250
  2. Sales ($mil) 12/2010 = 10513
  3. Sales ($mil) 12/2009 = 8703
  1. Annual EPS before NRI 12/2009 = 1.08
  2. Annual EPS before NRI 12/2010 = 1.39
  3. Annual EPS before NRI 12/2011 = 0.56

Dividend history

  1. Dividend Yield = 4.29
  2. Dividend Yield 5 Year Average 12/2011 = N/A
  3. Annual Dividend 12/2011 = 0.62
  4. Annual Dividend 12/2010 = 0.37
  5. Forward Yield = 5.71
  6. Dividend 5 year Growth 12/2011 = N/A
  1. Dividend sustainability
  2. Payout Ratio 06/2011 = 0.88

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -24.78
  2. Next 3-5 Year Estimate EPS Growth rate = 10.79
  3. EPS Growth Quarterly(1)/Q(-3) = 191.18
  4. ROE 5 Year Average 06/2011 = 18.75
  5. Return on Investment 06/2011 = 2.65
  6. Debt/Total Cap 5 Year Average 06/2011 = 45.93
  1. Current Ratio 06/2011 = 0.74
  2. Current Ratio 5 Year Average = 0.84
  3. Quick Ratio = 0.72
  4. Cash Ratio = 0.49
  5. Interest Coverage Quarterly = 1.66

Valuation

  1. Book Value Quarterly = 9.55
  2. Price/ Book = 1.17
  3. Price/ Cash Flow = 2.93
  4. Price/ Sales = 0.9
  5. EV/EBITDA 12 Mo = 5.22

Notes

It falls under the category of "good." The drop in net income to be a little worrisome though cash flow per share, sales and EBITDA have been rising for the past three years.

Company: Mobile Tele (MBT)

Levered Free Cash Flow = 1.11B

Basic Key ratios

Percentage Held by Insiders = 1

Market Cap ($mil) = 18099

Growth

  1. Net Income ($mil) 12/2011 = 1444
  2. Net Income ($mil) 12/2010 = 1381
  3. Net Income ($mil) 12/2009 = 1014
  4. 12months Net Income this Quarterly/ 12months Net Income 4Q's ago = 5.63
  5. Quarterly Net Income this Quarterly/ same Quarter year ago = 151.8
  1. EBITDA ($mil) 12/2011 = N/A
  2. EBITDA ($mil) 12/2010 = 4837
  3. EBITDA ($mil) 12/2009 = 3885
  4. Net Income Reported Quarterlytr ($mil) = 393
  5. Annual Net Income this Yr/ Net Income last Yr = 4.59
  6. Cash Flow ($/share) 12/2011 = N/A
  7. Cash Flow ($/share) 12/2010 = 3.61
  8. Cash Flow ($/share) 12/2009 = 3
  1. Sales ($mil) 12/2011 = 12319
  2. Sales ($mil) 12/2010 = 11293
  3. Sales ($mil) 12/2009 = 9867
  1. Annual EPS before NRI 12/2007 = 2.1
  2. Annual EPS before NRI 12/2008 = 2.01
  3. Annual EPS before NRI 12/2009 = 2.7
  4. Annual EPS before NRI 12/2010 = 3.82
  5. Annual EPS before NRI 12/2011 = 1.47

Dividend history

  1. Dividend Yield = 4.72
  2. Dividend Yield 5 Year Average 12/2011 = N/A
  3. Annual Dividend 12/2011 = 0.86
  4. Annual Dividend 12/2010 = 0.82
  5. Forward Yield = 4.73
  6. Dividend 5 year Growth 12/2011 = N/A

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.59
  2. Payout Ratio 5 Year Average 06/2011 = 0.37
  3. Change in Payout Ratio = 0.22

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -20.15
  2. Next 3-5 Year Estimate EPS Growth rate = 13.4
  3. EPS Growth Quarterly(1)/Q(-3) = 135.48
  4. ROE 5 Year Average 06/2011 = 34.78
  5. Return on Investment 06/2011 = 13.78
  6. Debt/Total Cap 5 Year Average 06/2011 = 47.24
  1. Current Ratio 5 Year Average = 0.86
  2. Quick Ratio = 0.89
  3. Cash Ratio = 0.58
  4. Interest Coverage Quarterly = 4.35

Valuation

  1. Book Value Quarterly = 3.86
  2. Price/ Book = 4.96
  3. Price/ Cash Flow = 4.79
  4. Price/ Sales = 1.47
  5. EV/EBITDA 12 Mo = 4.69

Notes

It would fall in the range of average-good. Net income and sales have been trending up for the past three years but it sports a weak current ratio, quick ratio and annual EPS before NRI took a hit in 2011.

Company: Kinder Morgan (KMI)

Levered Free Cash Flow = 292.94M

Basic Key ratios

Market Cap ($mil) = 21037

Growth

  1. Net Income ($mil) 12/2011 = 594
  2. Net Income ($mil) 12/2010 = -41
  3. Net Income ($mil) 12/2009 = 495
  4. 12 months Net Income this Quarterly/ 12months Net Income 4Q's ago = 1196.15
  5. Quarterly Net Income this Quarterly/ same Quarter year ago = 147.22
  1. EBITDA ($mil) 12/2011 = 2817
  2. EBITDA ($mil) 12/2010 = 2221
  3. EBITDA ($mil) 12/2009 = 2775
  4. Net Income Reported Quarterlytr ($mil) = 156
  5. Annual Net Income this Yr/ Net Income last Yr = 1539.57
  1. Cash Flow ($/share) 12/2011 = 2.83
  1. Sales ($mil) 12/2011 = 8265
  2. Sales ($mil) 12/2010 = 8191
  3. Sales ($mil) 12/2009 = 7185

Dividend history

  1. Dividend Yield = 3.16
  2. Dividend Yield 5 Year Average 12/2011 = N/A
  3. Annual Dividend 12/2011 = 0.74
  4. Annual Dividend 12/2010 = 0
  5. Forward Yield = 3.16
  6. Dividend 5 year Growth 12/2011 = N/A

Dividend sustainability

  1. Payout Ratio 06/2011 = 1.79

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = 24.93
  2. Next 3-5 Year Estimate EPS Growth rate = 26.06
  3. Return on Investment 06/2011 = 1.97
  4. Debt/Total Cap 5 Year Average 06/2011 = 61.46
  1. Current Ratio 06/2011 = 0.37
  2. Current Ratio 5 Year Average = 0.48
  3. Quick Ratio = 0.33
  4. Cash Ratio = 0.13
  5. Interest Coverage Quarterly = 3.55

Valuation

  1. Book Value Quarterly = 14.37
  2. Price/ Book = 2.73
  3. Price/ Cash Flow = 13.88
  4. Price/ Sales = 2.55
  5. EV/EBITDA 12 Mo = 12.41

Notes

It would fall under the category of "good." Net income, EBITDA and sales have been improving over the past few years. Additionally EPS is projected to trend upwards for the next few years.

Parker Hannifin Corp. (PH)

Industry: Industrial Machinery and Equipment

Levered Free Cash Flow: 1.10B

Growth

  1. Net income for the past three years
  2. Net Income 2009 = $509 million
  3. Net Income 2010 = $554 million
  4. Net Income 2011 = $1049 million
  1. EBITDA 12/2011 = $1853 million
  2. EBITDA 12/2010 = $1221 million
  3. EBITDA 12/2009 = $1153 million
  4. Net income Reported Quarterly = $371 million
  1. Total cash flow from operating activities
  2. 2009 = $1.13 billion
  3. 2010 = $1.22 billion
  4. 2011 = $1.17 billion
  1. Cash Flow 12/2011 = 8.56 $/share
  2. Cash Flow 12/2010 = 5.69 $/share
  3. Cash Flow 12/2009 = 5.4 $/share
  1. Annual EPS before NRI 12/2011 = 6.37
  2. Annual EPS before NRI 12/2010 = 3.4
  3. Annual EPS before NRI 12/2009 = 3.13
  4. Annual EPS before NRI 12/2008 = 5.61

Performance

  1. ROE = 20.7%
  2. Return on Assets = 10.34%
  3. Quarterly Earnings Growth = 4.6%
  4. Quarterly Revenue Growth = 8.4%
  1. Price to Sales = 1.05
  2. Price to Book = 2.61
  3. Price to Tangible Book = 11.63
  4. Price to Cash Flow = 10.6
  5. Price to Free Cash Flow = 17.4
  1. Current Ratio 09/2011 = 1.91
  2. Current Ratio 5 Year Average = 1.7
  3. Quick Ratio = 1.21
  4. Cash Ratio = 0.38
  5. Interest Coverage 09/2011 = 15.27
  6. Total return last 3 years = 148%
  7. Total return last 5 years = 57%

Dividend sustainability and history

  1. Payout Ratio 09/2011 = 0.21
  2. Payout Ratio 06/2011 = 0.22
  3. Payout Ratio 5 Year Average 09/2011 = 0.25
  4. Payout Ratio 5 Year Average 06/2011 = 0.25
  5. Change in Payout Ratio = -0.04
  1. Dividend yield 5 year average = 1.8%
  2. Dividend growth rate 3 year average = 16.58%
  3. Dividend growth rate 5 year average = 17.71%
  4. Consecutive dividend increases = 7 years
  5. Paying dividends since = 1949

Notes

It would fall under the category of "great." Net income, cash flow per share, EBITDA, sales and annual EPS before NRI have all been increasing over the past three years. It also sports a very good interest coverage ratio of 15, has consecutively increased dividends for seven years, has been paying dividends since 1949, has a very low payout ratio, an excellent five-year dividend growth rate of 17% and a good ROE of 20%.

Disclaimer

This list of stocks is meant to serve as a starting point. Please do not treat this as a buying list. It is imperative that you do your due diligence and then determine if any of the above plays meet with your risk tolerance levels. The Latin maxim caveat emptor applies-let the buyer beware.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: EPS, Price, EPS surprise charts obtained from zacks.com. A major portion of the historical data used in this article as obtained from zacks.com. Consensus estimate analysis table sourced from reuters.com.

Source: 5 Dividend Plays: 2 Exceptional, 2 Good And 1 Middle Of The Road