Investing in Dividend Companies (Key Ratios Cont..)

Dividend Investing Main Topic: A New Approach Section 3: Dividend Companies and How to Select the Best of Them
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Transcript

Great to have you back. Let's begin where we left off. Now that we have looked at the short term liquidity ratios, we also must look at the long term liquidity ratios which are called solvency ratios. These ratios assess the long term financial viability of a business, ie its ability to pay off its long term obligations, such as bank loans and bonds payable. Key solvency ratios that dividend investors look out for our debt to capital ratio, net debt to EBIT ratio, interest coverage ratio or coverage ratio. And now I'll start with debt to capital.

Financial leverage can be dangerous. Those of us who have felt the pains paring down student loan debts or an excessive home mortgage understand that borrowed money can be a persistently hard to overcome situation if we overextend our A similar notion applies to companies as well. And that is why you should look at a company's debt to capital ratio. Because this ratio tells you how much debt a company is using to run its business. debt to capital is also known as gearing ratio and is calculated by dividing total debt by total assets. Assuming company X has $200 million worth of assets means that $200 million is acquired by some combination of debt and equity.

So, if company X has $100 million of debt in total, we say that company X has a debt to capital ratio or gearing up 50%. If company X has 150 million dollars of debt, the gearing will increase to 75%. The next question is how high should accompanies gearing be to trigger concern is a gearing of 75% too high Is 50% just nice? The right answer is to compare the gearing with industry average or peer average. It could be the industry that company x is in. For example, utilities allows for higher leverage than other industries due to the reliability of their earnings.

If company x is a tech company with few tangible assets, it would be prudent to have a gearing ratio that is less than its industry average. But how can investors like yourself obtain the industry or peer average data to compare? The answer is you either have to pay for such data or calculate it yourself by gathering firms of the same nature accumulating their guarantees and averaging them out quite a tedious endeavor. If you can't get the industry leverage to compare with your target company, the rule of thumb is to invest in companies with a debt to capital ratio, no high Than 50% gearing. With that said, companies that are laden with too much debt open themselves up to unnecessary risks, and we don't want those types of companies in our dividend portfolios. net debt to EBIT a compliment to the debt to capital ratio, which focuses on the company's capital structure.

The net debt slash EBIT ratio compares a company's debt to its earnings. The idea behind this financial ratio is that a company with a seemingly high level of debt might not be as risky as it appears if it is generating a lot of profits and has plenty of cash on hand. Take note that net debt is the difference between company's total debt and its cash and short term investments. So for example, if a company had $100 of debt and $10 of cash, its net debt would be $90 divided net debt by EBIT, we can calculate how many years it would take a business to pay off its debt using its cash on hand and annual operating profits. Suppose Pepsi had $100 billion of debt $10 billion of cash on hand, and $45 billion of EBIT last year. Pepsi's net debt would be $90 billion $100 billion of debt less $10 billion of cash dividing net debt $90 by Pepsi's EBIT $45 gives us a net debt to EBIT ratio of 2.0.

In other words, Pepsi could theoretically eliminate its debt with cash on hand and two years worth of operating profits. As a rule of thumb, dividend investors generally prefer to invest in companies with a net debt to EBIT ratio no greater than about two but companies with more stable earnings can afford somewhat higher leverage ratios. interest coverage ratio coverage ratios measure the risk inherent in lending to the business in the long term. complimentary to solvency ratios. Coverage ratios include debt coverage ratio, interest coverage ratio and fixed charge coverage ratio for selecting dividend stocks, considering the interest coverage ratio would suffice. This coverage ratio will give you a quick picture of a company's ability to pay the interest charged on its debt.

A large interest coverage ratio indicates that a company will be able to pay the interest on its debt even if its earnings decrease. Conversely, a small interest coverage multiple sends a caution signal. So what constitutes a decent interest coverage multiple The answer is at least three times Three times interest coverage is a rule of thumb figure. It is considered the minimum acceptable amount for a mature company, a company with years of track record or asset heavy companies. To illustrate the interest coverage ratio, let's assume that a corporation's most recent annual income statement reported net income after tax of $500,000 interest expense of $150,000 and income tax expense of $100,000. Given these assumptions, the corporation's annual income before interest and income tax expenses is $750,000.

Since the interest expense was $150,000, the corporation's interest coverage ratio is five times $750,000 divided by $150,000 of annual interest expense. So that is how you find the interest coverage ratio, which is usually provided in the annual report financial highlights. If not, you can always calculate this ratio yourself. Next, we have the all important cash flow ratios. Cash Flow ratios help you to better assess the quality of a business's earnings. They provide a more unbiased assessment of the business's earnings and give insights into with sustainability.

So, the cash flow ratios to focus on are fcf per share, net cash per share. fcf per share. There are two forms of free cash flows, free cash flow to equity FC f e and free cash flow to firm FC FF In short, the difference. FC FF represents the amount of cash flow that is available for distribution among all security holders. Security holders include debt, preferred stockholders and common stockholders. In other words, it is the cash flow that is available to the entire firm, FC FF and weighted average cost of capital goes hand in hand in valuing a company.

FC f e, on the other hand represents the amount of cash flow an equity holder directly receives by investing in a firm, FC FF may be preferred to fcf e if, for instance, the company's capital structure is expected to change significantly in the future, perhaps due to a merger. So, which to use. The problem with FC FF is that an investor who basis his investment decision on FC FF heeled runs the risk of developing overly optimistic expectations. Although the distinction is less important when companies already have low levels of debt, taking into account these two factors going forward We'll be using FC FP instead of FC FF. Companies that fail to generate free cash flow to equity are typically capital intensive businesses. As dividend investors, we prefer to invest in companies that can generate free cash flow, whatever the nature of the businesses.

When it comes to dividend investing, we just look into its patterns that the company has clocked in over the years. For example, mature stable companies tend to have flat fcf figures, which looks something like this. cyclical companies tend to have periods where their fcf fee per share is negative and periods where it is really positive. fast growing companies might have low or even negative FCP as much of the cash could be tied up with new customers on laxer credit terms. Ideally, we want our dividend companies to have at least positive fcf fee for the past five years and Amongst these past five years, the FCC should not have a drastic fall in any of those years. If we demand constantly increasing FCC fees from our dividend companies, we might only end up with established low yielding companies in our dividend portfolio, hence too restrictive and thus specifically for implementing dividend investing strategy follow this f CFE rule of thumb if you're not sure about this f CFE rule of thumb and would like more clarification, feel free to email me Okay, now for net cash per share.

Benjamin Graham's favorite ratio, its formula is simple. Take all the cash and marketable securities found on the company's balance sheet minus all the debt both short and long term debts divided by the total number of outstanding shares the net cash per share has many interpretations, it can tell you how safe or attractive or how underutilized the company is. It is viewed as a safety ratio because should the worst happen at the very least, the company is cash rich and can pay the investors back in cash. It is also viewed as attractive for the possibility of a buyout from other companies or competitors trying to consolidate for a better future. And it can be viewed as underutilized if the company does not explain or do anything with the huge cash pile for long periods of time. dividend investors hope that the cash rich company will announce special dividends because somehow or another if the company doesn't use the cash to invest in other projects, they should return that excess cash to investors.

As such an increasing amount of net cash per share year on year is something dividend in Investors look out for not many companies will have a net cash position, mind you. So if you're using this net cash ratio to filter out dividend companies don't be too strict on the requirements or criteria. For me, as long as the dividend company that I'm looking at has evidence of clocking in decent free cash flows, it is still a POS in my books, even though it is not in a net cash position. Now that we have finished with cash flow ratios, we will look at the dividend payout ratio and the other important ratios. dividend payout ratio, the dividend payout ratio is perhaps the most common financial ratio used by dividend investors. It measures how much of a company's earnings are paid out as dividends.

To calculate a company's dividend payout ratio simply divide the company's last year's dividends over its earnings. If you used expected dividend per share divided by expected earnings per share, you get a forecast and dividend payout ratio. Investors like to analyze the dividend payout ratio because it gives them insights into how much room The company has for future growth. A high payout ratio for example, above 70% could mean that the dividend payment is at risk because the payout consumes most of a company's earnings. If business trends unexpectedly fall, there might not be enough profits to keep paying the dividends. dividend growth can also be more difficult for companies with high dividend payout ratios unless earnings growth is equally strong.

Generally, a lower payout ratio means a company's dividend is more sustainable and has room to grow. Some quick things to note, younger companies generally have lower payout ratios because they want to reinvest more of their earnings in order to keep growing. established. Stable companies, on the other hand, generally use more of their earnings to reward shareholders and thus sport higher payout ratios. The point of all these is that I prefer to invest in dividend paying companies with payout ratios of no more than 60%. Finally, we look at two more ratios, the price earnings ratio PE and the price to book ratio PV touching on the P e ratio First, there are two ways to calculate this.

The first way is share price dividend divided by earnings per share or VPS. The second way is market capitalization, which is the current share price multiplied by total number of shares, then the total divided by net income for the earnings do know that this figure is usually taken from the trailing 12 months and can be found by checking the income statement for the past four quarters. Pe using trailing month figures is often called the current PE. Now we use current PE for dividend investing because just like the other investing styles, whether growth or value investing in dividend investing, we also do not like to buy dividend companies that are overvalued. There are a few ways to use the P e ratio. First we can compare it with the general market.

For example, the s&p 500 average p E is 15.6 times the lowest it has ever reached was 5.3 times in 1917 and the highest was 123 point 73 times in May 2009. Some investors would use this range as a gauge to time they're buying entry if s&p 500 is closing in on 100 23 times, the investor will pause his or her purchase and wait for a correction. This is one way to time your buying entry. The second way which is my preferred way of using PE is to compare the dividend company's current PE with its industry's latest PE average or peer group PE latest average. Just like the ratios we've already gone over finding the industry or peer group averages can be difficult for some investors if this is the case. The third way to use PE is to compare the dividend company's current PE with its 52 week high PE.

For example, if the company's current PE is 15 times and its 52 week PE is 16 times then since 15 is very close to 16. The investor again would avoid buying into that company. This is contrary to many traders strategy where they will buy a stock when the price action Seeds it's 52 week high or sell when the price falls below its 52 week low due to price momentum in that direction. But we are not traders, we are investors. So the way we interpret certain ratios can be starkly different. Now as for the PB ratio, the usage is the same as for PE, it's just that the formula is different.

Instead of earnings per share, we use book value per share. As you can see from the formula, we use PB on dividend companies with high amounts of tangible assets like property developers, pe NPV, just like net cash per share are just complimentary ratios. They should not take precedence over the other ratios that we have analyzed. What I mean by this is when you scan for a dividend paying company and find one that has good margin track records, decent interest coverage, and healthy, free cashflow, but its share price is trading near or slightly over its PE or PB ratio. My suggestion is still to buy into the company as good dividend companies are usually fairly priced. Just don't overpay for a dividend paying company.

Unless you are lucky enough to have spotted one that is trading at a low p e or PB ratio then by all means, get the stock. Alright, so we have come to the end of the first portion. In the next video. We will be doing some quantitative analysis with these ratios. See you there

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