Investing in dividend paying stocks is part-science and part-art. Figuring out intangibles, like the quality of management, is an art. Everything else requires a scientific approach. The cold hard numbers never lie, but you need to understand them intimately if you’re going to figure out whether a stock is a good investment.
Being able to dissect a company’s balance sheet to figure out how much it’s worth is an essential skill. To make things easier, professional investors often rely on key financial ratios. These ratios can tell you everything you need to know about the financial state and future potential of an investment.
If you’re getting started with an income-generating portfolio, here are the top ten financial ratios you need to know:
Dividend payout ratio
This is, perhaps, the most important ratio for a dividend seeking investor. The payout ratio is the amount of money paid out in dividends from total earnings. For example, if a company earns $10 per share and pays out $2 per share in dividends each year, the payout ratio is 20%.
This is an important metric that tells a deeper story about the company. If the payout ratio is too high it means the company’s management doesn’t have a lot of investment opportunity within the business and would rather pay back most of the money made during the year. A higher payout ratio is also riskier because the management doesn’t have much wriggle room if earnings become volatile.
On the other hand, a low payout ratio means the management is holding back a majority of earnings for reinvestment into the business. Usually, faster growing companies have lower payout ratios. These companies have a lot of breathing room to increase dividends if earnings grow substantially over the coming years.
A good dividend company strikes the right balance and has a payout ratio that’s justified. 3M company is a good example. The company has managed to maintain a payout ratio between 30% and 50%. That means it has paid one-third to half of its earnings every year in dividends. Meanwhile, dividends have grown 10% annually over the past ten years. A stable payout ratio and growing dividends means the company’s earnings have been increasing at an impressive clip.
Free cash flow per share
Free cash flow is arguably more important than earnings. It’s the basis of intrinsic value, as we’ve seen before. But it’s also a source of dividends which is why it’s important to check for regular, consistent, and growing cash flows. FCF/share is a ratio that shows how much cash was generated per share after all capital expenditures were taken care of.
Free cash flow has one of two places to go – investors pockets or the bank. Some industries are too competitive and capital intensive to allow companies to make free cash flows. United States Steel Corp (X) is a good example. Over the past ten years the company’s FCF has been as unpredictable as the price of steel. On the other hand, Paychex (PAYX) has managed to sustain and grow its free cash flow every year for the past decade. The business is profitable and operates in the asset-light human resources outsourcing business. This reflects in the dividend program as well, as PAYX yield 3.03% in annual dividends.
Return on Capital Invested
We’ve already discussed return-on-equity. It’s the ratio of earnings to shareholders equity, which is a key metric for understanding how valuable a business is. An an equity investor, you want ROE to exceed, the yield on treasury bonds and the returns from the general stock market.
But equity is only one part of the total business. Most companies have at least a little bit of debt on the books. How do you compare companies with different ratios of debt-to-capital? That’s where return on capital employed or ROCE comes into play. The ratio is calculated by dividing EBIT (earnings before interest and taxes) by Capital Employed (shareholder’s equity and debt). In other words, it shows how well the whole business operates and how efficiently it uses its total capital.
Operating profit margin
A higher profit margin means there’s more room for free cash flows and dividends to grow. The ratio divides operating profits with total sales to show how profitable the business is. Of the 5,000 companies listed on the stock market, the average operating profit margin is 12%. Anything higher than this is a clear indication of a competitive edge. The more profitable it is, the wider the economic moat.
Not a lot of investors know about asset turnover, but it’s a rather important financial ratio for dividend investing. The ratio is calculated by dividing the total sales by total assets. It’s a way to figure out how much revenue a company can generate by squeezing its assets. A higher ratio means the company is more efficient. Walmart is a great example of this. The company’s profit margins are barely 5%, but it can maintain a higher ROE (18.56%) because it makes more than $2.36 in sales for every dollar in assets (asset turnover = 2.36).
Sales growth is a straightforward metric that can show you how stable a business is. The ratio is simply calculated by dividing the increase in sales by the sales of the previous period. Healthy and consistent sales growth shows a business has stable operations and operates in a predictable industry. Consistent growth eventually translates to better profits and higher dividends.
Too much leverage could be lethal. Debt-to-capital is an important financial ratio for dividend investing because it allows investors to see if the debt burden is too heavy. A little bit of debt is okay, so long as it is manageable. Generally, this ratio should be lower than 50% if you’re looking for a safe dividend stock investment.
Net debt / EBIT
While debt-to-capital focuses on the capital structure of a firm, net debt/EBIT shows how manageable the debt is. The ratio divides the net debt (debt minus cash) by the earnings before interest and taxes in a certain period. The ratio can be thought of as the number of years it would take the company to completely pay off its debt with cash on hand and annual earnings. Preferably, a company should have a ratio of less than 2.
Probably the most popular and enduring financial ratio for dividend investing is the PE ratio. The stock price divided by the earnings per share is likely to show you how cheap (or expensive) the company is. Another way to think of it is as the number of years the company would take to earn back the amount you invest in it today. So a PE ratio of 5 means the company will earn back the dollar amount you invest today within five years.
As a rule of thumb it’s best to look for companies that are trading at a PE ratio less than the market average. The S&P 500 is currently trading at 25.76x.. A company trading at less than that ratio could be considered a bargain.
Total shareholder return
The dividend yield is one of the most tempting financial ratios for dividend investing. Income seekers often get obsessed with it. But what good is a 10% yield if the stock price falls 50% by the time it is paid? Capital gains and dividend income need to be accounted for together if you want to see how your investment has performed over the year.
That’s where total shareholder return comes in. It’s a ratio of share price growth including dividends over a previous period. Let’s take Exxon Mobil (XOM) as an example. Over the course of 2016, the stock increased from $77.46 to $90.26 – an increase of 16.52%. The dividend paid was $3 per share. So, if you bought one XOM stock on Jan 1, 2016 and sold it on Jan 1, 2017, you total return would be 20.4% ($90.26 + $3 – $77.46 / 77.46). Meanwhile, the S&P 500 offered a total shareholder return of 9.54%over the course of 2016.
Keeping an eye on your total return is crucial if you want to sustain and grow wealth through investing in dividend stocks.
There are hundreds of financial ratios for dividend investing, but not all of them are useful. The ten ratios we’ve mentioned here are some of the most insightful and popular metrics used by investment professionals.
Analyzing a stock from multiple aspects is an important step towards building a rock-solid dividend portfolio. Apply these ratios to every investment to give it a thorough health check before you invest your hard earned cash.