The most used and referenced ratio on Wall Street is the price to earnings ratio. The P/E ratio divides the price per share by the earnings per share of a company. Earnings or net income is the profit that a company generates within a period of time. Profitability is important because profits ultimately become retained earnings on a company’s balance sheet, and this adds to shareholder’s equity. This would bring value to the shareholder and is the very basis of being a value investor. Profitability is important for any business, both private and public. I personally wouldn’t want to invest in a company that doesn’t generate any income, but that’s just me. Going through a company’s income statement is a basic task any serious investor should do before investing in any type of business. However, Wall Street’s infatuation with this particular ratio seems excessive.
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I’m sure you’ve heard that, in general, stocks priced above a P/E ratio of 25 could be considered overvalued and that you should look for stocks around a P/E ratio of 20 or lower depending on the growth of the company. These ratios can be important in showing how much a person is willing to pay for the earning of a company. Would you want to pay 20 or 25 times a company’s earnings? Quite frankly, P/E ratios could be ignored by value investors interested in dividends, and here’s why.
Dividends are paid in cash, not in earnings. In fact, just about every important transaction a company conducts is done in cash. Companies pay their expenses in cash. The pay debt in cash. They pay employees in cash. They eventually receive cash for their product or services. So why is there so much emphasis on earnings? Accrual Accounting and its implications.
Using this accounting method, companies can recognize revenue before the cash transaction takes place. Sometimes there are contracts that allow a company to recognize revenue over a period of time, although cash may not be received until after the contract or another agreed upon time. The purpose is to match the company’s expenses with its revenues. Now there isn’t anything wrong with accrual accounting for the most part. The problem is that different companies can recognize revenues in different ways in order to raise or lower their P/E ratios. Also, every company doesn’t pay dividends, and if they did they would pay it in cash, not in earnings.
I’m sure you’ve also heard the saying that “cash flow is king”, so I’m not going to say it here. But the cash flow statement is the most important yet underrated of the financial statements. I’d even say that if I could only use one financial statement to value a company, I’d use the cash flow statement. Every transaction eventually lands on the cash flow statement, and for a value investor seeking dividends, cash flow is everything.
After paying all of its expenses, companies use the cash to reinvest in new projects for their business to grow. Companies can also use their cash to pay a dividend to their shareholders, and each task isn’t mutually exclusive. As value investors, we should think of ourselves as business owners and not stock speculators that want to simply sell their shares at a higher price. As business owners, we should want our businesses to pay us back. After all, what’s the point of investing if you don’t earn a return on it? Most of all, we want to receive cash in the form of dividends, or a stock dividend in a dividend reinvestment plan.
So then, what should a good value investor like you use when seeking out dividend payments from the businesses you invest in? The price to cash flow ratio, or even free cash flow if we want to dig for even deeper value. For me, free cash flow and cash flow show a company’s true cash generating abilities. Let’s look at SLM Corp., a business I have in my portfolio. This is, of course, not an in-depth analysis. I simply want to drive a point home.
SLM Corp. is better known as Sallie Mae, and makes loans to students that want to further their education. SLM’s P/E ratio is 2.90, which simply means investors are willing to pay almost three times the earnings of SLM to own it. As a savvy investor, you already know that P/E is worthless when it comes to dividends, so lets look at price to cash flow and free cash flow. P/CF is 2.8 and P/FCF is 2. This tells me that SLM’s is priced at about 2 to less than 3 times its cash generating ability! In general, I like to invest in companies that have a P/CF ratio of 15 and under. SLM also pays a very nice dividend of 7.19%. Of course, this isn’t always an indication of a buying opportunity, it is always important to look at the company’s income statement, balance sheet and cash flow statement before making any investment decision. Ratios should simply be used when trying to screen investments for your portfolio. Just make sure you’re focusing on the more important ones.
Full Disclosure: I am Long SLM