How To Evaluate Dividend Stocks
This article was originally written by Jason Evans at thepeartreeeffect.com.
Dividend investing can be a great way to achieve passive, cash flow income. Heading in blind does not help so the investor has to go through financial information to pick the best investment in their eyes for their needs and not the needs of others.
Investors can use the company's statement of cash flow, earnings per share ratio, as well as the price to earnings ratio to help decide if the investment may not be as good as it seems.
This is going to be based on a perspective on using dividend stocks to generate long-lasting passive income. Of course, there are ways for management to manipulate financial statements so this is not to be taken as a hard factor in determining what is a good investment and what is a bad investment.
There are, however, about three factors to be considered: Statement of Cash Flows, earnings per share [EPS], and the price to earnings ratio [P/E].
The EPS formula is (Net Income – Preferred Dividends) / Shares Outstanding; this formula produces a ratio. A higher number is usually better but that is not always the case.
EPS can be manipulated by management to appear different from actual results. Tax accountants often have to separate the difference between “realized” and “recognized” earnings. Some amounts may be recognized but not yet realized.
This happens a lot in financial statements with large long term assets as well as financial instruments which is why the other things we want to look at are the company’s cash flow and the price point, using price to earnings ratio.
We use the Statement of Cash Flows to find out where cash inflow is earned capital that we want, as compared to contributed capital.
Better than that, you want to see where the earned capital comes from… is it because they had a liquidation sale and had to sell all of their assets they use to operate? Is it because of their day to day operating activities selling their products or services? Or did they take a new loan to finance their activities or issue more shares to raise capital? These are three ways to increase the cash flow in, yet there is a big difference in each of them so your analysis is important. We can find all of this out on the Statement of Cash Flows.
You see, technically, dividends must come out of retained earnings. If the company does not have retained earnings, then the cash flow out of the company to investors is considered a liquidating dividend.
As a dividend investor, our goal is to make sure a company has adequate retained earnings, as well as enough cash flow coming in to cover a growing dividend as well as the operating needs to continue to grow the company. Are the stocks worth a 6x multiple or are the stocks overpriced?
Now let us look at the price to earnings ratio. The price to earnings[P/E] for the S&P 500 on December 31st, 2006 was at 17.40, compared to 23.68 on December 31st, 2016. Comparing these numbers you would say the average company is valued six times higher compared to earnings as they were ten years ago. Now that can be a good thing or a bad thing depending on why the market is valued six times higher than it was.
After that you want to compare the same P/E with the average for a company in the same industry. The P/E will be very different depending on different industries. At this point, you will still be looking at the company in question, then you think it fared well at the P/E test.
If the stock is valued correctly for its industry and compared to the S&P, then it may be time to see if the dividend stock is a proper stock to provide passive income. There are two numbers that brings you to the payout ratio.
You first want to look at the company's EPS, and compare it with the cash flow. Remember when we were checking where the inflow of cash came from? You want to make sure enough of the earnings are coming from operating cash flow. If the cash flows come from operating, then you want to compare the dividend to the EPS. I know this gets a little confusing but if you write it down it is really easy to compare.
For an example, say that the companies EPS is $3.00/share and the dividend to common shareholders happens to be $1.00 per share. Do you know what this means? It means that the company pays out 33.3% of their earnings, leaving the company with 66.6% of the earnings.
Now it would be great news if the company was investing the earnings into future operations [Again, shown on the Statements of Cash Flows]. At the same time this means that the valuation of the company should go down by 1/3rd of the earnings and up by 2/3rds or the earnings that stay in the company.
That is all in theory though.
What it means to investors is that the company is earning more than they are giving back to investors and have enough to invest in themselves, which means there is room for the dividend to safely grow.
Now let us see if the payout was reversed and EPS was still $3.00/share but now the dividend is $2.00/share. This shows that the stock can cover the dividend, but there is not a lot of room for the company to increase the dividend to its shareholders until the earnings increase.
This sets up a flag of caution we should notice. Now, there is also a balance where the EPS is $3.00/share and the dividend is $1.50/share. That is a balance of 50/50. Overtime you hope the earnings will increase and so will the dividend, but at the same team leaving money in the company to invest in itself for the future and give money back to its investors at the same time. The sweet spot is hard to find and changes in a developing company compared to a developed company.
Using EPS, Statement of Cash Flows, and P/E is not a perfect vetting process, but can easily raise red flags on many companies. Using the EPS to see if a company earns enough to cover a growing dividend, Statement of Cash Flows to see where the money is coming from and going to, and the P/E to see how a company is valued can steer you in the right direction.
Thanks for reading! If you're looking to learn more about the perks of dividends and cash flow over capital gains, there is some great info right here.
Tell us in the comments below: Do you own any dividend stocks? Which are your favorites?
Stay awesome. Have a great day.
Are We "Best Content On The Internet" Worthy?
No annoying popups, no frustrating spam begging for your email address.
If you don't think we publish the best content on the internet, we don't think we deserve to get to know someone as great as you.
If you do, well here ya go.
Copyright Information: Copyright Elite Happiness. This content may be freely reproduced in full or in part in digital form with full attribution to the author and a link to www.elitehappiness.com. Please contact us for permission to reproduce this content in other media formats.
Disclaimer: We at Elite Happiness are awesome, but we are not licensed professionals. These are not recommendations and should be viewed only for entertainment purposes.
Disclosure: I do not have positions in any of the mentioned stocks and have no intention of opening a position for 72 hours following this writing.