Welcome to step 6 of this comprehensive guide. First and foremost, I explain why a dividend is so important to investors. Then, I explain how much of a dividend a company should pay, and then move on to other parameters.
This section covers a lot of important ground and each of these parameters diversifies your stock picking requirements to reduce risk.
Simply put, this step makes sure that the entire picture of the stock looks good. As with all parameters examined in the stock picking process, each category should be regarded with equal weight. The categories for Investing for Beginners 101 are as follows.
1. Why to Invest?
2. How the Stock Market Works
3. The BEST Stock Strategy and Buying Your First Stock
4. P/E Ratio: How to Calculate the Most Widely Used Valuation
5. P/B, P/S: The Single Two Ratios Most Correlated to Success
6. Cashing In With a Dividend Is a Necessity
7. The Best Way to Avoid Risk, and Putting it all Together!!
A Dividend Creates Compounding Interest
The first parameter we want to examine is the dividend yield of a company. This aspect is important because a good investment is constantly returning cash to the shareholders. Receiving a dividend and reinvesting that dividend is so crucial for you in utilizing the power of compounding interest. Dividends are guaranteed return on investment, and as I’ve said before I never suggest buying a stock that pays no dividend. A healthy dividend yield and dividend payout reflects a company that is using excess cash efficiently. It’s really as simple as that, but it is also very important. That being said let me show you how to calculate these parameters.
Dividend yield is quite easy to calculate, and will often be explicitly stated next to a stocks price as a %. For those who are more ambitious and want to be able to accurately calculate this % at all times, just divide dividends the company paid for the year by the current share price.
Dividend yield % = dividend/share price
The only hard part about this is finding the information. You can quickly Google this to find it out, however if you are researching years prior it’s really good to know how to extract this from the 10-k annual report. What I do is once you have the annual report document open, hit Ctrl+F to search for “dividends”. You can also search “quarter” or “quarterly” to see the dividends paid along with share price numbers for each quarter of the year you are looking at. Sometimes the dividend paid is included in the statement of income, which helps out if you are filling out spreadsheets.
Next we want to know dividend payout %. If a company had too high of a %, this could indicate a company being irresponsible. It also commonly warns of a company in trouble who is trying to hide its balance sheet failures by still paying high dividends. On the surface the company may still seem to be in good shape, but a prudent investor who has done his/her due diligence will be able to identify this by use of the payout ratio. To calculate this, take the dividend paid for the year divided by the company’s EPS (earnings per share found in the statement of income).
Payout ratio % = dividend / EPS
The next parameter to consider is price to cash, or P/C, ratio. This ratio reflects the profitability of a company and their ability to generate cash. Basically by buying a company with a low P/C ratio, you are getting access to their cash flow at a low price. A stock with a P/C of 10 means you are paying $10 for $1 of cash generated. Over time, a ratio of 10 or lower will usually pay the investor great dividends, both literally and metaphorically.
Many well respected investing figures swear by the price to cash ratio, notably Warren Buffett and Porter Stansberry. The ability for a company to convert profits into cash is absolutely essential, and is uncovered by the P/C ratio. To derive this ratio, simply divide a company’s market capitalization by their net cash at end of year.
P/C = market cap/ net cash
To find the net cash at end of year, scroll down to statement of cash flows in the 10-k annual report. This section can be found directly below either the balance sheet or statement of income. Near the bottom of the page lies the net cash numbers, organized by year.
Earnings: Don’t Get Pulled In but Be Aware
Last but not least is the parameter of earnings growth. Earnings are the name of the game for most investors, and therefore it can’t be ignored. While earnings can be manipulated and don’t show the whole picture, they are useful for discovering momentum. High earnings usually correlate with a high stock price. Popularized by mutual fund phenom Peter Lynch in his bestselling book Beating the Street, so called growth investors’ primary focus is earnings growth. And because it is so widely popular, the type of stocks with good earnings growth can be volatile, as minor changes in growth can cause major upswings or downswings because of the multitude of investors focusing so intently on growth.
For example, a highflying stock with stellar growth may see its growth slow down, and in turn many growth investors might see this as unfavorable and their selling could drive the stock low very quickly. Because of this volatility, earnings growth becomes only one part of my investing strategy instead of the whole focus. A good long term plan won’t be adversely affected by such short term swings.
Earnings growth percentage is calculated by subtracting the previous years earnings from current year earnings and dividing by previous year’s earnings and multiplying this quotient by 100 to get the percentage.
Earnings growth =100* (Current earnings – last year’s earnings) / last year’s earnings
To increase accuracy and get a better feel for how much a company is growing over a longer time period, average the warnings growth percentage over the 3 most recent years. For example, if earnings growth for a company was:
Then the average earnings growth for the company is (2.4+4.6+3)/3 = 3.33%.
A good earnings growth is around 3%, and indicates a stock with a very possibly bright future.
Make sure to catch the last and final step to Investing for Beginners 101. The topic covered is the BEST way to avoid risk, how this ratio prevents catastrophic losses and then the final step to putting it all together to make precise buy and sell decisions.