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    Basic Ratios for Building a Dividend-Based Stock Portfolio

    by Don Schreiber Jr.

    Stock prices rise, and stock prices fall. But there is one constant in stock investing, and that is dividends. Dividends arrive every quarter, pretty much without fail.

    There are five advantages dividend-paying stocks can provide investors:

    • They provide a steady stream of income;
    • Over the long term they offer growth through share price appreciation, which helps increase the real (after-inflation) value of an investor’s portfolio;
    • Dividend reinvestment allows your investment to grow at a compounded rate of return;
    • Dividend reinvestment also promotes dollar-cost averaging; and
    • Dividend-paying stocks generally have lower price volatility than non-dividend-paying stocks, since during market declines the dividend stream becomes more important to investors.
    In fact, under just about any market conditions, history provides compelling evidence of the benefits of a diversified portfolio of dividend-paying stocks—in particular, for investors who are just starting out and perhaps more risk-averse, and for those already in retirement. And with the changes in the tax laws regarding the tax treatment of dividend income, dividend-focused investing is even more advantageous.

    Of course, that doesn’t mean that all dividend-paying stocks are good investments. As with any stock, you need to be selective, basing your choice on a fundamental evaluation of the underlying business and the stock price. In addition, dividends are not guaranteed. You don’t want to purchase a security on the basis of its dividend, only to have the dividend cut or eliminated shortly after your purchase.

    Where do you start?

    If you don’t have a crystal ball or inside information, the best way to pick and choose is by analyzing a company’s financial position through the use of a few key ratios, using information that can be easily found, primarily in a firm’s financial statements. Publicly traded companies publish their financial statements in their annual report to shareholders. You can obtain an annual report on any public company simply by contacting the company’s shareholder services department and requesting the report or going to the Securities and Exchange Commission Web site (www.sec.gov).

    In this article, we’ll walk you through the basic building blocks you need to get you started analyzing dividend-paying stocks.

    Building Blocks

    We suggest you use two basic building blocks to start your analysis:

    • Basic financial metrics, and
    • Ratio analysis.
    Basic Financial Metrics
    These are formulas that allow you to view any company’s results on a per share basis. Once financial data are reduced to the shareholder level, you can easily compare companies that might be very different in size or in different industries.

    Table 1 shows the basic financial metrics that can be used to build a dividend stock–focused portfolio. For the most part, the calculation is relatively straightforward; the source of the information from the company’s financial statements is included in Table 1. Of course, there are other sources of information for these basic numbers—newspapers and stock data vendors are just two examples. The table, however, shows how the numbers are originally calculated.

    TABLE 1. Basic Financial Metrics
    Financial Metric Formula Data Source
    Sales per share Sales ÷ no. of shares outstanding Income statement; balance sheet
    Earnings per share Earnings (net income) ÷ no. of shares outstanding Income statement; balance sheet
    Dividends per share Dividends ÷ no. of shares outstanding Retained earnings statement; balance sheet
    Cash flow per share Operating cash flow ÷ no. of shares outstanding Cash flow statement; balance sheet

    Ratios
    Ratios allow you to analyze a company’s financial performance against other companies in the same industry, against all stocks in the market, or against industry standards.

    Although there are a great number of ratios you can use to analyze a company, in this article we have developed a short list of basic ratios that will give you the fundamental information you need to pick good dividend-paying stocks (summarized in Table 2).

    TABLE 2. Basic Ratios for Dividend-Paying Stocks
    Ratio Formula Data Source
    Dividend Yield
    Dividend Yield Dividends per share ÷ price per share Dividend per share; newspaper (for daily price)
    Liquidity Ratio
    Quick ratio (Current assets – inventory) ÷ curr. liabilities Balance sheet
    Debt Coverage Ratio
    Short-term debtcoverage ratio Operating income ÷ short-term debt (currrent liabilities) Income statement; balance sheet
    Valuation Ratio
    Price-earnings ratio Stock price ÷ earnings per share Newspaper; basic metric formula
    Dividend Ratios
    Payout ratio Dividends per share ÷ earnings per share Basic metric formulas
    Dividend coverageratio Cash flow per share ÷ dividends per share Basic metric formulas
    Growth Ratios
    Revenue growth rate ratio Current year revenue less last year’s revenue ÷ last year’s revenue Income statement
    Earnings growth rate ratio Current year earnings less last year’s earnings ÷ last year’s earnings Income statement

    Dividend Yield

    The dividend yield is calculated by dividing the dividend per share by a firm’s stock price.

    While most companies don’t change their dividend payouts frequently, stock prices do change all day long, so yield must be calculated each time you analyze a stock.

    At a minimum, we would generally recommend only considering stocks with yields at least equal to that of the S&P 500 index.

    You should be aware that the highest-yielding stocks tend to be concentrated in a few industries. This may change as more companies move to take advantage of the new tax treatment of dividends and boost their payouts to investors. However, be careful to structure your portfolio so that it is diversified, and not concentrated in particular industries. Since higher-yielding stocks tend to have different strengths, weaknesses and prospects than lower-yielding stocks, you can improve the diversity of your portfolio by allowing for some of each.

    Since yield is dividend divided by price, usually high yields can be the result of either rising payouts or, more typically, falling prices. Prices may be under pressure if investors are expecting the dividend to be cut, or if they’re expecting some other bad news to follow shortly. To the extent this perception is incorrect, a high yield may be another expression of value. In these cases, investors are “paid to wait” for the company to turn its fortunes around.

    The key is to find high-yielding stocks that are not in the process of going out of business and have the cash flow and financial resources to continue paying the high dividend you’re hoping to collect. This is where the basic ratios come into play.

    Quick Ratio

    The quick ratio is an important liquidity ratio that is computed by removing inventory from current assets (assets that are liquid), and then dividing the remainder by current liabilities (short-term debts the firm must pay within a year). All three data points—current assets, inventory, and current liabilities—are found in a firm’s balance sheet. Since inventories are typically the least liquid of a company’s current assets and are likely to produce a loss if liquidated, it is prudent to look at the firm’s ability to cover short-term liabilities without relying on them.

    The rule of thumb is that a company with a quick ratio of 1.0 or better indicates that it could cover all current liabilities with the liquid assets it has on hand, thereby reducing any need to cut its dividend. If the ratio were less than 1.0, you would want to assure yourself that the company is generating enough cash flow from operations to cover both its normal expenses and any short-term debt obligations that come due.

    The bottom line is the higher the quick ratio, the better we like the company, but it should have a minimum of 1.0.

    Debt Coverage Ratios

    The short-term debt coverage ratio allows you to quickly see if the company’s short-term debt obligations can be easily paid by using the cash that is being generated from company operations. This ratio is calculated by dividing income from operations (from the income statement) by current liabilities or short-term debt (from the balance sheet). This ratio should equal at least 2.0.

    A short-term debt coverage ratio of 2.0 or greater means that the company is generating more than twice the cash flow it needs from operations to pay off all of its short-term obligations. Taken by itself, this ratio would indicate that the dividend is pretty secure and would also indicate that there is sufficient operating income to offset a slightly lower liquidity position if that were indicated by the company’s quick ratio.

    Leverage allows a company to grow faster and so may enhance the return on investor capital. But it will also increase risk. Since too much leverage strains the company’s ability to pay the debt back, creditors and dividend investors prefer companies with moderate debt levels. Greater asset coverage cushions a company during negative cash flow periods and should allow the company to maintain its dividend payment even during tough times.

    Income from operations is an important measure of the ability of a firm to generate positive cash flow from normal operations without liquidating other assets to fund expenses and dividend payments. In addition to operating income, interest income on cash balances is another source of income. Other income items can include the sales of assets (i.e. products, patents, or even an entire operating division or subsidiary)—however, these are one-time income events and can distort an investor’s perception of the company’s ability to generate income. That is why we use operating income in our formulas as a much more reliable indication of cash flow. Other income for a company may be akin to your winning a $10,000 windfall from a lottery ticket—it can be spent or reinvested when received, but you can’t count on it to happen again to cover next year’s bills.

    Valuation Ratios

    Our focus is on finding dividend-paying stocks that are good values, so we also look at valuation ratios in an effort to buy stocks at an attractive price. We have a value focus and would rather buy stocks at a low price today, so we can sell them at a higher price later. That helps us avoid the classic mistake many investors make of buying high and selling low.

    We look to buy stocks that are cheap not only by historical standards, but also in comparison to other stocks. Value stocks typically have less downside risk because they are already down. They also tend to have more upside potential; often there is nowhere to go but up.

    If you can find a stock that is a good value, it usually means that the stock has fallen from the market’s grace. Maybe the company is struggling with its product mix or has had labor problems or there may be a new competitor. At any rate, investors have abandoned the stock, its price has fallen, and the immediate prospects for a turnaround are a bit murky. If the company’s business and stock price seem to have stabilized, you may want to consider buying it.

    Of course, a company’s dividend yield may be one indicator of value, as we discussed. However, another important ratio that can help you identify companies with good value characteristics is the price-earnings ratio (P/E). Also known as the price-to-earnings multiple, this ratio tells you how expensive the stock is from a price standpoint, given the earnings that the stock is generating. Historically, stocks are a good value when the ratio or multiple is around 14, although we will consider stocks that have a P/E of up to 20 if there are other compelling reasons to hold the stock. However, the lower the ratio, the better. You calculate the ratio by dividing the stock’s price by the earnings per share being generated.

    Dividend Ratios

    When a company earns profits, the management must decide whether to retain earnings for growth or pay a portion of the profits out to stockholders in the form of cash dividends.

    Two additional important ratios will help further determine the security of the dividend income stream and, thus, the attractiveness of a stock.

    Dividend Coverage Ratio
    This ratio shows how secure the dividend is based on the cash flow being generated by the company. Instead of looking at cash flow to analyze whether the company can meet its debt obligations, we use this ratio to assess how easily the company can keep making its dividend payments. To calculate this ratio, you divide cash flow per share by dividend per share. The higher the dividend coverage from cash flow, the better we like it. Our minimum rule of thumb is a dividend coverage ratio of 1.2, indicating 120% of the dividends are covered by cash flow.

    Dividend Payout Ratio
    This ratio tells you how much profit the company is paying out to shareholders in dividends. Once again, the higher the better, as long as the ratio does not exceed 100%. Since a company can only pay dividends from current or retained earnings, it is a warning sign if a company is paying dividends that exceed current earnings.

    The dividend payout ratio is calculated by dividing a firm’s dividend per share by its earnings per share. We suggest looking for companies that have payout ratios of at least 50%, which to us indicates that the company is committed to rewarding shareholders through dividend payouts, and allows management to consider increasing dividends as earnings increase.

    Growth Ratios

    Year-over-year growth and shrinkage in revenue and earnings are good indications of a positive or negative trend developing. The importance of confirming a positive trend when analyzing value stocks cannot be overstated. Remember, it would not be a value stock if there weren’t something wrong. However, without confirming a positive trend, you could invest in a stock that will continue to slide, eventually cut its dividends and may even go bankrupt.

    Two growth ratios will help you identify these trends.

    One-Year Revenue Growth Ratio
    This ratio measures the one-year percentage change in revenue growth. It is calculated by subtracting last year’s revenue from the current year’s revenue to find the difference, and then dividing that difference by last year’s revenue to find the percentage change. Our suggested rule of thumb is to look for at least a 10% increase.

    One-Year Earnings Growth Ratio
    This ratio measures the one-year percentage change in earnings growth. It is calculated by subtracting last year’s earnings from the current year’s earnings to find the difference, and then dividing that difference by last year’s earnings to find the percentage change. Our suggested rule of thumb here is also to look for at least a 10% earnings growth rate. And with both revenue and profits rising, a firm’s stock price should reflect this positive trend and move higher.

    Trend Analysis

    One ratio by itself does not tell a story, but several taken together provide a much clearer picture of a firm’s strengths and weaknesses. While the preceding ratio analysis gives a reasonably good picture, it is missing the important component of time.

    All of the preceding ratios are snapshots of the company’s financial condition at a single point in time. But there are trends in motion that need to be identified so you can understand if the company’s position is improving or deteriorating.

    Year-over-year trend analysis looks at the various ratios over the last five years. What you should look for is a generally positive trend with increasing growth in sales, earnings, cash flow, and dividends per share. In addition, the leverage, value and dividend ratios should for the most part be positive or well within acceptable ranges.

    Temper Rules With Judgment

    A parting caution is in order. Although convenient, rules of thumb should not be adhered to in isolation. For example, electric utilities normally have current liabilities that exceed their current assets, yielding a quick ratio of less than 1.0. However, investors are not concerned because utilities have strong cash flow from operations and their accounts receivables are from electricity users who must pay their bills if they want to continue to receive electricity. If your rule of thumb were rigid, a low quick ratio would be a signal for you to avoid the company and discard promising stocks individually or even across an entire industry.

    Ultimately, by integrating these basic ratios into a single analysis for any given company, you should be able to confidently select dividend-paying stocks that will help you to accomplish your investment goals and to build your wealth slowly over time through compounding dividends and price appreciation.

    TABLE 3. Basic Ratio Rules of Thumb
    Dividend yield Yield at least equal to that of the S&P 500. Do not focusonly on the highest-yielding stocks; diversify amongvarious levels of dividend yield
    Quick ratio The higher the better, but should be minimum of 1.0
    Short-term debt coverage ratio Should equal at least 2.0
    Price-earnings ratio Stocks are a very good value when ratios are 14.0 or below;the lower the ratio the better
    Dividend coverage ratio The higher the better; minimum coverage of 120%
    Dividend payout ratio The higher the better—preferably above 50%—but shouldnot exceed 100%
    One-year revenue growth rate Look for at least 10% growth
    One-year earnings growth rate
    Trend analysis Look for positive trends—increasing growth in sales,earnings, cash flow and dividends; liquidity, debtcoverage, value and dividend ratios within acceptable ranges


    Don Schreiber Jr. is the founder, president and CEO of Wealth Builders, Inc., a financial advisory firm based in Little Silver, New Jersey. Gary E. Stroik is vice president, portfolio manager and chair of the investment committee at Wealth Builders. Mr. Schreiber and Mr. Stroik are also authors of “All About Dividend Investing,” published by McGraw-Hill (www.allaboutdividends.com).


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