What indicators may signal company success? Are some metrics better than others?

There are dozens of metrics you can use to evaluate a company.

Metrics offer a quantitative take on a company’s financial health. They offer details for investment decision-making and they can offer some insight into future results.

However, you can sometimes make numbers say anything you would like with the appropriate amount of ‘massaging’. There are drawbacks. Metrics are good but usually only for a point in time, based on the best information available. Further still, metrics can’t always measure company intangibles such as management and leadership attributes. Lastly, while some metrics can be helpful, not all may be accurate – you know as well as I do that everyone’s crystal ball is cloudy.

Despite their constraints, metrics can be very valuable for investors. This article will offer my take on some of the metrics I use to select and hold dividend paying stocks in my portfolio, and offer a take from Ryan Modesto, Managing Partner of 5i Research Inc.

We hope you enjoy our point and counter points as we talk dividend metrics 101.

Dividend Yield

Mark:

I think this is one of the easiest metrics to use. This metric is a measure of how much a company pays out in dividends as a percentage of its share price.

The calculation and example:

Annual dividends / price per share = yield

BCE annual dividends = $2.40 / $60 = 4%.

I think you want to own companies that have a low-to-modest yield. I like owning companies that yield between 3-5%. I focus on Canadian banks, utilities and telecommunications companies in my portfolio. High yields (anything over 6%) could be warning sign for trouble – they are a concern for me.

Ryan:

It is hard to argue the value of dividends. It is hard to beat doing nothing and getting paid for it. It is even better when those dividends increase over time. Sometimes investors put too much importance on dividends. There is obviously nothing wrong with them, but excluding companies that do not pay dividends can be risky in that it can lead to a concentrated portfolio or concentration on a style of stock. Value stocks, growth, low-beta, you name it, are all styles with merit but no single style will outperform 100% of the time. Owning a bit of the companies that don’t pay a dividend allow for this diversification. We do prefer dividend growers to high dividend payers but agree that more often than not, the enticing high yielders are usually a red flag and are often some of the more risky names an investor can own. Dividends are great, but don’t be fooled by a high yield.

Earnings Per Share (EPS)

Mark:

Businesses are in business to make money. At least as a shareholder, I hope so!

Earnings per share are the portions of the company’s profits divided by the number of common shares outstanding over a defined period of time (e.g., one year).

 

The calculation and example:

 

Net income – dividends on preferred stock / outstanding shares = EPS

 

If a company earns $2 million in one year and had 2 million common shares outstanding, and no preferred stock, then the EPS = $1 per share.

 

There are EPS growth rates, prospective EPS metrics and more but I won’t go into those at this time.

 

I think you want to own companies that have a high EPS or rising EPS with time. This is because rising profits are good for companies and investors in those companies alike. Investors, who focus on owning companies that grow their EPS over time, can potentially reap the benefits of increased dividends, if the company Board of Directors decides on that.

 

Think of earnings per share of a company like your own wage per hour – I think you should want you want more of it over time.

 

Ryan:

 

The more earnings the better but there is a bit of a nuance here. More earnings mean more taxes are being paid which means less money for ‘you’. Non-cash items such as depreciation and one-time costs that may not occur in the future also impact earnings per share. These factors can allow management to make adjustments and subjective decisions that put the company in a better light or may not reflect a true or normalized picture of the company. EPS is an important metric, but we like to focus more on cash flow than EPS. Dividends, at the end of the day, are paid out of cash flow and depreciation charges have no real impact on a company’s ability to pay that dividend (in the short to medium term at least).

 

Dividend Payout Ratio

 

Mark:

 

This is a great metric for dividend investors like myself. This is the ratio of company profits paid to shareholders, usually expressed as a percentage.

 

The calculation and example:

 

Annual dividends / EPS = ratio

 

TD Bank annual dividends = $2.20 / 4.7 = 47%

 

I believe it’s a good idea to own companies that have a low-modest payout ratio, say consistently under 70%. Companies with high dividend payout ratios may be unable to sustain their dividend, they may need to cut their dividend or in dire cases, the dividend might be eliminated. This is probably a good time to bring up some differences between common stocks – how they reward their shareholders via dividends - and how Real Estate Investment Trusts (REITs) rewards their shareholders via distributions.

 

You see many REITs use cash flow to pay their distributions. REITs, for accounting purposes, also depreciate their assets. This reduces their net income but it’s also part of the reason why you shouldn’t be overly concerned with REITs paying out a high(er) percentage of their distributions to their shareholders, at least in the short-term. REITs pay distributions from their adjusted funds from operations (AFFO) not from net income. So what’s the right payout ratio for REITs? REITs are cyclical but I think anything below 90% is little cause for concern.

 

My takeaway message is this – companies and REITs can’t fake dividends or distributions for long so when in doubt own companies that have a history of modest payout ratios.

 

Ryan:

 

The payout ratio is a very important indicator when looking at a dividend. In general, if the payout ratio is low based on earnings, it will probably be ok all else equal. Of course, some industries can maintain higher payouts than others depending on the stability of the company. We did a deep dive into this topic earlier on the 5i website (http://www.5iresearch.ca/blog/looking-at-the-dividend-payout-ratio-all-wrong).

 

Cash Flow

 

Mark:

 

As a follow-up to what I wrote about above, cash flow for companies is a good thing. We all like more money flowing into our accounts than going out. Rising cash flow over time is therefore a great thing.

 

Rising (positive) cash flow means the company’s assets are increasing; they can settle debts; reinvest in the business and of course, return more money to shareholders – raise their dividend – if they want to. Negative cash flow is a sign the company is underwater; at least temporarily because there are more accounts due than received or payments pending that have yet to be received.

 

Cash flow calculations have a fair bit of accounting involved so I won’t go into all details, but under the accrual accounting method (counting chickens before they hatch per se) – you’ll want to hold companies that have rising cash flows over time. At least this is what I prefer

 

Table example courtesy of TMX Money; image date February 1, 2017

 

http://www.tmxmoney.com/en/index.html

 

I like seeing the companies I own with stable and generally more cash flow over time.

 

Ryan:

 

No arguments here! We think cash flows are important and typically will not bother looking at a company that does not have positive cash flows.

 

Dividend Growth Rate

 

Mark:

 

Rising EPS, good cash flow, dividend payout ratios are important and those elements combined together typically give way to dividend growth.

 

Dividend growth, over time, means you can calculate a dividend growth rate. The dividend growth rate is the annualized percentage rate of a company’s dividend growth over a defined period of time (e.g., could be a 5-year dividend growth rate; could be a 10-year dividend growth rate).

 

A sound history of dividend growth can signal future dividend growth is likely, although as you already know, the future is always uncertain.

 

The calculation – suppose this is the annual dividends paid by fictional company "My Own Advisor Inc":

 

Year 1 = $1.00

 

Year 2 = $1.06

 

Year 3 = $1.09

 

Year 4 = $1.12

 

Year 5 = $1.17

 

To calculate the growth rate within any given year:

 

Year X Growth Rate =Year X Dividend / ((Year X - 1 Dividend) – 1))

 

Example:

 

Year 1 growth rate = n/a

 

Year 2 growth rate =1.06 / 1.00 – 1 = 6%.

 

You can also take an average of these growth rates over time in the form of compound annual growth (CAGR).

 

Example:

 

The dividend growth rate from year 1 to 5 is = 4%

 

I think you want to own companies that have a modest dividend growth rate. Too low, say under 1%, and that could be sign the company is struggling to reward shareholders. Too high, say over 10%, the company might be overly enthusiastic about long-term company prospects. With dividend history, it’s always important to keep in mind past performance does not guarantee future results but history often tells us a story about what tomorrow could bring.

 

Ryan:

 

As touched on earlier, we far prefer dividend growth to high dividends. It typically means the company is growing the bottom line and also has financial flexibility. If they were unable to pay debts and bills, it would be tough to raise the dividend. We would not be too concerned over big dividend increases and actually view it as a positive signal (as well as first dividends). Context is important though. If a company has a 100% payout ratio and does a big dividend raise, that could be a problem, but if they have a 25% payout ratio and do a 20% increase, it should not be a big problem. Especially if good growth is offsetting any increase.

 

Mark:

 

Those are my favourites. What else would you look at, Ryan?

 

Ryan:

 

Other aspects to consider are revenue trends and debt. If revenue is consistently declining, a once healthy looking dividend can become a problem quickly. On the debt side, if a company is having trouble paying down debt or making interest payments, they probably shouldn’t be paying a dividend in the first place.

 

Mark:

 

When using any metrics for dividend paying stocks I believe it’s important, first, to have a sound financial plan before you buy any stock or financial product. I’m a big fan of putting my investment plan in place long before selecting products or stocks in my portfolio. I believe doing the opposite, putting products before plans almost always leads to mistakes or losses.

 

It probably goes without saying but as investors we want to avoid mistakes as much as we can. When in doubt about making any major financial decisions please consult a financial professional. I do as much as I can to be accountable to my portfolio decisions, you should do the same for yours.

 

 

 

Mark Seed is passionate about personal finance and investing and is the blogger behind My Own Advisor. Mark is currently investing in dividend-paying stocks and some low cost ETFs on his journey to financial freedom. He is almost halfway to his goal of earning $30,000 per year in tax-free and tax-efficient dividend income for an early retirement. You can follow Mark on his path to financial freedom here. You can follow him on Twitter @myownadvisor.