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 off by listing our play of choice.
Reasons to like Microsoft Corp (MSFT):
- A massive levered free cash flow of $19.02 billion
- A good 5 year dividend growth rate of 13.79%
- A low payout ratio of 30% and even better 5 year average payout ratio of 26%
- EPS growth rates for the next 3-5 years are projected at 8.83%
- A 5 year sales growth of 7% which is decent for a company of its size
- A long term debt to equity ratio of 0.19
- An acceptable yield of 2.6%
- A great profit margin of 32.5%
- Operating margins of 38%
- Net income increased from $14.5 billion in 2009 to $23.1 billion in 2011
- EBITDA increased from $22.3 billion in 2009 to $30.8 billion in 2011
- Cash flow per share increased from $2.01 in 2009 to $3.02 in 2011
- Sales increased from $58.4 billion in 2009 to $69.9 billion in 2011
- Annual EPS before NRI increased from $1.49 in 2007 to $2.65 in 2011
- A very good 5 year average ROE of 44.8%
- Year over year projected growth rate of 12.3% for 2013
- A strong current ratio of 2.86
- A great quick ratio of 2.56
- A splendid interest coverage ratio of 77
- A great free cash flow yield of 10.14%
- $100K invested for 10 years would have grown to $145K; if the dividends were reinvested the rate of return would be much higher
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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 and Procter & Gamble.
The following criteria apply only to dividend paying stocks and not to growth stocks that might not payout 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
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 better handle of the ratios explained below you can create your own list of criteria. Investors might find our latest article to be of interest Seadrill Ltd. Among 5 Growth Candidates To Reflect On
Many key ratios will be covered in this article and investors would do well to get handle on some of the more important ones which are dealt with below.
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.
Free cash flow yield is obtained by dividing free cash flow per share by the current price of each share. Generally lower ratios are associated with an unattractive investment and vice versa. Free cash flow takes into account capital expenditures and other ongoing costs associated with the day to day to functions of the business. In our view free cash flow yield is a better valuation metric then earnings yield because of the above factors.
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 - Is It Worth Getting Into Alcoa?
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 $5, then the company trades at 20 times-free cash flow. This ratio is also useful because it can be used as a comparison to the average within the industry. This gives you an idea of how the company you are interested in holds up to the other companies within the industry.
Cash ratio this is the ratio of the company's total cash and cash equivalents to its current liabilities; this ratio is used as a measure of a company's liquidity. It allows investors to determine how fast the company would be able to pay its short term debts if push came to shove. Higher numbers are better because it makes it easier for a company to ask for new loans, increase in credit lines, etc.
Interest coverage is usually calculated by dividing the earnings before interest and taxes for a period of one year by the interest expenses for the same time period. This ratio informs you of a company's ability to make its interest payments on its outstanding debt. Lower interest coverage ratios indicate that there is a larger debt burden on the company and vice versa. For example if a company has an interest ratio of 11.8, this means that it covers interest expenses 11.8 times with operating profits.
Levered free cash flow is the amount of cash available to stock holders after interest payments on debt are made. A company with a small amount of debt will only have to spend a modest amount of money on interest payments, which in turn means that there is more money to send to shareholders in the form of dividends and vice versa. Freeport McMoRan 1 Of 5 Eye Catching Plays
Company: Emerson Electric Company (EMR)
Levered Free Cash Flow = 2.37B
- Net Income ($mil) 12/2011 = 2480
- Net Income ($mil) 12/2010 = 2164
- Net Income ($mil) 12/2009 = 1724
- Cash Flow ($/share) 12/2011 = 4.46
- Cash Flow ($/share) 12/2010 = 3.8
- Cash Flow ($/share) 12/2009 = 3.26
- Sales ($mil) 12/2011 = 24222
- Sales ($mil) 12/2010 = 21039
- Sales ($mil) 12/2009 = 20915
- Annual EPS before NRI 12/2009 = 2.27
- Annual EPS before NRI 12/2010 = 2.69
- Annual EPS before NRI 12/2011 = 3.24
- Dividend Yield = 3.3
- Dividend Yield 5 Year Average =2.8%
- Dividend 5 year Growth = 9%
- Payout Ratio 06/2011 = 0.51
- Payout Ratio 5 Year Average 06/2011 = 0.47
- Next 3-5 Year Estimate EPS Growth rate = 11.5
- EPS Growth Quarterly(1)/Q(-3) = 120.64
- ROE 5 Year Average 06/2011 = 23.45
- Current Ratio 06/2011 = 1.40
- Current Ratio 5 Year Average = 1.43
- Quick Ratio = 1.12
- Cash Ratio = 0.42
- Interest Coverage = 14.20
Company: CF Industries Holdings Inc (CF)
Levered Free Cash Flow = 1.7B
- Net Income ($mil) 12/2011 = 1539
- Net Income ($mil) 12/2010 = 349
- Net Income ($mil) 12/2009 = 366
- EBITDA ($mil) 12/2011 = 3209
- EBITDA ($mil) 12/2010 = 1304
- EBITDA ($mil) 12/2009 = 798
- Net Income Rpt Qtr ($mil) = 439
- Anl EPS before NRI 12/2009 = 7.8
- Anl EPS before NRI 12/2010 = 8.62
- Anl EPS before NRI 12/2011 = 22.9
- Cash Flow ($/share) 12/2011 = 30.85
- Cash Flow ($/share) 12/2010 = 13.44
- Cash Flow ($/share) 12/2009 = 10
- Div 5yr Growth 12/2011 = N/A
- Sales ($mil) 12/2011 = 6098
- Sales ($mil) 12/2010 = 3965
- Sales ($mil) 12/2009 = 2608
- Div Yield = 1.6
- Div Yield 5 Yr Average 09/2011 = 0.43
- Div 5yr Growth 12/2011 = N/A
- Payout Ratio 09/2011 = 0.07
- Payout Ratio 06/2011 = 0.09
- Payout Ratio 5 Yr Average 09/2011 = 0.04
- Change in Payout Ratio = 0.03
- Average EPS Surprise Last 4 Qtr = 11.5
- Next 3-5 Yr Estimate EPS Growth rate = 18.67
- 5 Yr Historical EPS Growth 09/2011 = 32.54
- ROE 5 Yr Average 09/2011 = 29.7
- Current Ratio 09/2011 = 1.74
- Current Ratio 5 Yr Average = 2.05
- Quick Ratio = 1.45
- Cash Ratio = 1.19
- Interest Coverage 09/2011 = 25.76
Company: Pepco Holdings (POM)
Levered Free Cash Flow = $-272 million
Basic Key ratios
- Relative Strength 52 weeks = 64
- Cash Flow 5 -year Average = 3.11
- Net Income ($mil) 12/2011 = 257
- Net Income ($mil) 12/2010 = 32
- Net Income ($mil) 12/2009 = 235
- EBITDA ($mil) 12/2011 = 1089
- EBITDA ($mil) 12/2010 = 849
- EBITDA ($mil) 12/2009 = 1016
- Cash Flow ($/share) 12/2011 = 3.12
- Cash Flow ($/share) 12/2010 = 2.98
- Cash Flow ($/share) 12/2009 = 2.49
- Sales ($mil) 12/2011 = 5920
- Sales ($mil) 12/2010 = 7039
- Sales ($mil) 12/2009 = 9259
- Annual EPS before NRI 12/2009 = 0.91
- Annual EPS before NRI 12/2010 = 1.24
- Annual EPS before NRI 12/2011 = 1.25
- Dividend Yield = 5.7
- Dividend Yield 5 Year Average 12/2011 = 5.63
- Dividend 5 year Growth 12/2011 = 0.58
- Payout Ratio 06/2011 = 0.91
- Payout Ratio 5 Year Average 12/2011 = 0.81
- Next 3-5 Year Estimate EPS Growth rate = 4
- EPS Growth Quarterly(1)/Q(-3) = 144.44
- ROE 5 Year Average 12/2011 = 7.13
- Current Ratio 06/2011 = 0.77
- Current Ratio 5 Year Average = 0.95
- Quick Ratio = 0.7
- Cash Ratio = 0.2
- Interest Coverage Quarterly = 1.45
Novartis AG Common Stock (NVS)
Levered Free Cash Flow: 11.8B
- Net income for the past three years
- Net Income 2009 = $8400 million
- Net Income 2010 = $9794 million
- Net Income 2011 = $9113 million
- EBITDA 12/2011 = $11524 million
- EBITDA 12/2010 = $12394 million
- EBITDA 12/2009 = $10473 million
- Total cash flow from operating activities
- 2008 = $9.67 billion
- 2009 = $12.2 billion
- 2010 = $14.07 billion
- Cash Flow 12/2011 = 5.52 $/share
- Cash Flow 12/2010 = 5.25 $/share
- Cash Flow 12/2009 = 3.72 $/share
- Annual EPS before NRI 12/2009 = 3.7
- Annual EPS before NRI 12/2008 = 3.59
- Annual EPS before NRI 12/2007 = 2.81
- ROE = 20.1%
- Return on Assets = 10.81%
- Quarterly Earnings Growth = -16%
- Quarterly Revenue Growth = -2.2%
- Current Ratio 09/2011 = 1.04
- Current Ratio 5 Year Average = 1.41
- Quick Ratio = 0.78
- Cash Ratio = 0.34
- Interest Coverage 09/2011 = 8.25
Dividend sustainability and history
- Payout Ratio 09/2011 = 0.36
- Payout Ratio 5 Year average 09/2011 = 0.34
- Change in Payout Ratio = 0.02
- Dividend yield 5 year average = 2.9
- Current yield= 4.7%
- Dividend growth rate 5 year average = 18.24
- Consecutive dividend increases = 5 years
- Paying dividends since = 1992
The markets are still in a corrective phase and will most likely remain volatile for the better part of the second quarter. Long-term investors can use strong pullbacks to slowly start deploying money into long-term investments. One of the best ways to do this is by selling naked puts at strikes you would not mind owning the stock at.
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
Additional disclosure: EPS and Price vs. industry charts obtained from zacks.com. A major portion of the historical data used in this article was obtained from zacks.com. Earnings and growth estimates sourced from dailyfinance.com.