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It is easier to find a score of men wise enough to discover the truth than to find one intrepid enough, in the face of opposition, to stand up for it. - A.A. Hodge

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. Before we get into the suggested guidelines and explanation on some of the more important key ratios we would like to start off by listing our play of choice.

Reasons to be bullish on Nexen Corp (NXY):

  • A strong levered free cash flow of $1.25 billion.
  • Net income increased from $489 million in 2009 to $705 million in 2011.
  • EBITDA increased from $933 million in 2009 to $3.68 billion in 2011.
  • Cash flow per share skyrocketed from $0.98 in 2009 to $5.19 in 2011.
  • Annual EPS increased from $1.47 in 2009 to $2.46 in 2011.
  • A strong five year dividend growth rate of 21.7%.
  • Year over a year projected growth rates for 2012 and 2014 are 47% and 30% respectively.
  • It has a five year sales growth average of 9.76%.
  • A good long-term debt to equity ratio of 0.53.
  • Projected 3-5 year EPS growth rates of 7%.
  • A good five year ROE average of 17.2%.
  • A good interest coverage ratio of 7.9%.
  • $100K invested for 10 years would have grown to $379K.

We generally base our choice on the following factors.

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

Cash flow per share - It should be trending upwards for the past three 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 - When available, 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 (NYSE:LEG) and Procter & Gamble (NYSE:PG).

The following criteria apply only to 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 (NYSE:JAH).

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 than 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 some time. If the payout ratio continues to increase, the situation warrants close monitoring as this cannot last forever. If your tolerance for risk is 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 - BBT Corp. Our Play Of Choice Among Financials.

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 on capital expenditure, then its free cash flow is $300 million. If the share price is $100 and the free cash flow per share is $5, then the 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 a 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 - Standoff: Emerson Electric Vs. ABB ... Which One Prevail.

Company: Nexen Corp

Levered Free Cash Flow = 1.25B

Basic Key ratios

  1. Percentage Held by Insiders = 0.17

Growth

  1. Net Income ($mil) 12/2011 = 705
  2. Net Income ($mil) 12/2010 = 1162
  3. Net Income ($mil) 12/2009 = 489
  1. EBITDA ($mil) 12/2011 = 3680
  2. EBITDA ($mil) 12/2010 = 3008
  3. EBITDA ($mil) 12/2009 = 993
  1. Cash Flow ($/share) 12/2011 = 5.19
  2. Cash Flow ($/share) 12/2010 = 4.13
  3. Cash Flow ($/share) 12/2009 = 0.98
  1. Sales ($mil) 12/2011 = 6483
  2. Sales ($mil) 12/2010 = 5657
  3. Sales ($mil) 12/2009 = 5556
  1. Annual EPS before NRI 12/2007 = 2.46
  2. Annual EPS before NRI 12/2008 = 3.55
  3. Annual EPS before NRI 12/2009 = 0.97
  4. Annual EPS before NRI 12/2010 = 1.05
  5. Annual EPS before NRI 12/2011 = 1.47

Dividend history

  1. Dividend Yield = 1.3
  2. Dividend Yield 5 Year Average =0.8%
  3. Annual Dividend 12/2011 = 0.2
  4. Annual Dividend 12/2010 = 0.19
  5. Forward Yield = 1.07
  6. 5 year dividend growth rate= 21.7%

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.14
  2. Payout Ratio 5 Year Average 06/2011 = 0.11
  3. Change in Payout Ratio = 0.03

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -28.15
  2. Next 3-5 Year Estimate EPS Growth rate = 7
  3. EPS Growth Quarterly(1)/Q(-3) = -170
  4. ROE 5 Year Average 06/2011 = 17.26
  5. Return on Investment 06/2011 = 6.3
  6. Debt/Total Cap 5 Year Average 06/2011 = 43.63
  1. Current Ratio 06/2011 = 1.08
  2. Current Ratio 5 Year Average = 1.36
  3. Quick Ratio = 0.98
  4. Cash Ratio = 0.33
  5. Interest Coverage =7.9

Valuation

  1. Price/ Book = 1.25
  2. Price/ Cash Flow = 15.00
  3. Price/ Sales = 1.62
  4. Price/Free cash flow= 4.40

Points of interest

Production volumes for the first quarter averaged 202,000 boe/d, which was around the mid-point of expectations. The company generated cash flow from operations of $670 million ($1.27/share), reflecting solid operational performance, our significant weighting to Brent-priced oil and strong cash netbacks. Net income was also strong at $171 million ($0.32/share).

Company: Canadian Natural Resources Limited (NYSE:CNQ)

Levered Free Cash Flow = -$653M

Basic Key ratios

  1. Percentage Held by Insiders = 5
  2. Market Cap ($mil) = 36918

Growth

  1. Net Income ($mil) 12/2011 = 2675
  2. Net Income ($mil) 12/2010 = 1655
  3. Net Income ($mil) 12/2009 = 1391
  1. EBITDA ($mil) 12/2011 = 7690
  2. EBITDA ($mil) 12/2010 = 7163
  3. EBITDA ($mil) 12/2009 = 4581
  1. Cash Flow ($/share) 12/2011 = 5.65
  2. Cash Flow ($/share) 12/2010 = 5.89
  3. Cash Flow ($/share) 12/2009 = 4.96
  1. Sales ($mil) 12/2011 = 15483
  2. Sales ($mil) 12/2010 = 14697
  3. Sales ($mil) 12/2009 = 9820
  1. Annual EPS before NRI 12/2007 = 2.09
  2. Annual EPS before NRI 12/2008 = 2.51
  3. Annual EPS before NRI 12/2009 = 2.68
  4. Annual EPS before NRI 12/2010 = 2.3
  5. Annual EPS before NRI 12/2011 = 2.31

Dividend history

  1. Dividend Yield = 1.3%
  2. Dividend Yield 5 Year Average = 0.8%
  3. Forward Yield = 1.25
  4. Dividend 5 year Growth = 21.42%
  1. Dividend sustainability
  2. Payout Ratio 06/2011 = 0.15
  3. Payout Ratio 5 Year Average 06/2011 = 0.11
  4. Change in Payout Ratio = 0.04

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -35.35
  2. Next 3-5 Year Estimate EPS Growth rate = 8
  3. EPS Growth Quarterly(1)/Q(-3) = 1-122.22
  4. ROE 5 Year Average 06/2011 = 17.14
  5. Return on Investment 06/2011 = 8.64
  6. Debt/Total Cap 5 Year Average 06/2011 = 37.36
  1. Current Ratio 06/2011 = 0.69
  2. Current Ratio 5 Year Average = 0.75
  3. Quick Ratio = 0.55
  4. Cash Ratio = 0.04
  5. Interest Coverage Quarterly = 16.52

Company: Talisman Energy (NYSE:TLM)

Levered Free Cash Flow = -1.41B

Basic Key ratios

  1. Percentage Held by Insiders = 6.29
  2. Market Cap ($mil) = 13242

Growth

  1. Net Income ($mil) 12/2011 = 776
  2. Net Income ($mil) 12/2010 = 629
  3. Net Income ($mil) 12/2009 = 385
  1. EBITDA ($mil) 12/2011 = 4569
  2. EBITDA ($mil) 12/2010 = 3521
  3. EBITDA ($mil) 12/2009 = -329
  1. Cash Flow ($/share) 12/2011 = 2.94
  2. Cash Flow ($/share) 12/2010 = 2.19
  3. Cash Flow ($/share) 12/2009 = 0.17
  1. Sales ($mil) 12/2011 = 8272
  2. Sales ($mil) 12/2010 = 6712
  3. Sales ($mil) 12/2009 = 7028
  1. Annual EPS before NRI 12/2007 = 0.93
  2. Annual EPS before NRI 12/2008 = 1.91
  3. Annual EPS before NRI 12/2009 = 0.17
  4. Annual EPS before NRI 12/2010 = 0.13
  5. Annual EPS before NRI 12/2011 = 0.51

Dividend history

  1. Dividend Yield = 2.2
  2. Dividend Yield 5 Year Average =1.4%
  3. Forward Yield = 2.1
  4. Dividend 5 year Growth 12/2011 = 14.7%

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.93
  2. Payout Ratio 5 Year Average 06/2011 = 0.4
  3. Change in Payout Ratio = 0.53

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -49.21
  2. Next 3-5 Year Estimate EPS Growth rate = 8.5
  3. EPS Growth Quarterly(1)/Q(-3) = 1-133.33
  4. ROE 5 Year Average 06/2011 = 11.46
  5. Return on Investment 06/2011 = 5.48
  6. Debt/Total Cap 5 Year Average 06/2011 = 29.37
  1. Current Ratio 06/2011 = 0.65
  2. Current Ratio 5 Year Average = 0.95
  3. Quick Ratio = 0.6
  4. Cash Ratio = 0.16
  5. Interest Coverage Quarterly = 18.66

Company: Apache Corp (NYSE:APA)

Basic Key ratios

  1. Percentage Held by Insiders = 0.56
  2. Number of Institutional Sellers 12 Weeks = 5
  3. Relative Strength 52 weeks = 35
  4. Dividend 5-year Growth = 0
  5. Cash Flow 5 -year Average = 20.74
  6. Dividend Yield 5-Year Average = 0.63

Growth

  1. Net Income ($mil) 12/2011 = 4584
  2. Net Income ($mil) 12/2010 = 3032
  3. Net Income ($mil) 12/2009 = -285
  1. EBITDA ($mil) 12/2011 = 12297
  2. EBITDA ($mil) 12/2010 = 8289
  3. EBITDA ($mil) 12/2009 = 5539
  1. Cash Flow ($/share) 12/2011 = 23.36
  2. Cash Flow ($/share) 12/2010 = 17.22
  3. Cash Flow ($/share) 12/2009 = 21.05
  1. Sales ($mil) 12/2011 = 16888
  2. Sales ($mil) 12/2010 = 12092
  3. Sales ($mil) 12/2009 = 8615
  1. Annual EPS before NRI 12/2007 = 8.46
  2. Annual EPS before NRI 12/2008 = 11.61
  3. Annual EPS before NRI 12/2009 = 5.52
  4. Annual EPS before NRI 12/2010 = 8.92
  5. Annual EPS before NRI 12/2011 = 11.93

Dividend history

  1. Dividend Yield = 0.70
  2. Dividend Yield 5 Year Average 12/2011 = 0.63
  3. Forward Yield = 0.74

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.05
  2. Payout Ratio 5 Year Average 12/2011 = 0.07
  3. Change in Payout Ratio = -0.02

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -28.46
  2. Next 3-5 Year Estimate EPS Growth rate = 6.41
  3. EPS Growth Quarterly(1)/Q(-3) = -102.44
  4. ROE 5 Year Average 12/2011 = 17.99
  5. Return on Investment 06/2011 = 13.83
  6. Debt/Total Cap 5 Year Average 12/2011 = 21.99
  1. Current Ratio 06/2011 = 0.97
  2. Current Ratio 5 Year Average = 1.41
  3. Quick Ratio = 0.84
  4. Cash Ratio = 0.22
  5. Interest Coverage Quarterly = N/A

Company: Anadarko Petrol (NYSE:APC)

Basic Key ratios

  1. Percentage Held by Insiders = 0.19
  2. Relative Strength 52 weeks = 50
  3. Dividend 5-year Growth = 0
  4. Cash Flow 5 -year Average = 10.67
  5. Dividend Yield 5-Year Average = 0.63

Growth

  1. Net Income ($mil) 12/2011 = -2649
  2. Net Income ($mil) 12/2010 = 761
  3. Net Income ($mil) 12/2009 = -135
  1. EBITDA ($mil) 12/2011 = 1245
  2. EBITDA ($mil) 12/2010 = 6210
  3. EBITDA ($mil) 12/2009 = 4126
  1. Cash Flow ($/share) 12/2011 = 11.07
  2. Cash Flow ($/share) 12/2010 = 9.32
  3. Cash Flow ($/share) 12/2009 = 6.25
  1. Sales ($mil) 12/2011 = 13967
  2. Sales ($mil) 12/2010 = 10984
  3. Sales ($mil) 12/2009 = 9000
  1. Annual EPS before NRI 12/2007 = 8.34
  2. Annual EPS before NRI 12/2008 = 6.92
  3. Annual EPS before NRI 12/2009 = -0.96
  4. Annual EPS before NRI 12/2010 = 1.81
  5. Annual EPS before NRI 12/2011 = 3.38

Dividend history

  1. Dividend Yield = 0.5
  2. Dividend Yield 5 Year Average 12/2011 = 0.63
  3. Forward Yield = 0.5

Dividend sustainability

  1. Payout Ratio 06/2011 = 0.11
  2. Payout Ratio 5 Year Average 12/2011 = 0.2
  3. Change in Payout Ratio = -0.1

Performance

  1. Percentage Change Price 52 Weeks Relative to S&P 500 = -13.07
  2. Next 3-5 Year Estimate EPS Growth rate = 27.15
  3. EPS Growth Quarterly(1)/Q(-3) = -116.44
  4. ROE 5 Year Average 12/2011 = 6.93
  5. Return on Investment 06/2011 = 4.94
  6. Debt/Total Cap 5 Year Average 12/2011 = 39.25
  1. Current Ratio 06/2011 = 1.42
  2. Current Ratio 5 Year Average = 1.25
  3. Quick Ratio = 1.42
  4. Cash Ratio = 0.75
  5. Interest Coverage Quarterly = N/A

Conclusion

Long-term investors should wait for the market to let out some more steam before committing a large amount of money to this market as it is still rather overbought. A pullback in the 7%-12% from the peak would qualify as a strong pullback.

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.

Source: Nexen Our Favorite Pick Among 5 Candidates

Additional disclosure: EPS, charts obtained from zacks.com. A major portion of the historical data used in this article was obtained from zacks.com. Free cash flow yield, income from cont operations and revenue growth sourced from Ycharts.com. Consensus estimate analysis sourced from reuters.com. Earnings estimate and growth tables sourced from dailyfinance.com.