In the first half of chapter two of “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” author Mark Lowe covered four key metrics and concepts.
The second half of the chapter follows with four more metrics.
Dividend yield
This is a key measure for investors who are shopping for dividend stocks and shows the relationship between the annual dividend and the stock price. This is the formula: Dividend Yield = Yearly Dividend / Share Price.
That relationship means the yield will increase as the stock price decreases, and the yield goes down as the price increases. When assessing dividend stocks with high yields, it is essential to see whether the share price has dropped significantly and, if it has, why. All too often, yields look attractive because a company’s fortunes have been slipping.
Similarly, investors should remember that money paid in dividends is money not available for growing the company’s revenues, and potentially its profits. Is the high yield at the expense of needed reinvestments?
Lowe noted some companies should naturally have higher dividend yields, without experiencing distress. Mature companies that are no longer aggressively expanding have the highest yields; they include companies in the consumer staples or utilities sectors. On the other hand, we should expect small or no yields for tech companies.
In addition, he reported on a study showing that about 82% of profits registered by S&P companies (large, more mature companies) came from dividends.
Plowback ratio
There are only two destinations for earnings, dividends and retained earnings. The portion that goes into retained earnings may be plowed back into the company to generate future revenues, thus the term “plowback ratio.” It is simply the proportion of earnings not being paid out as dividends.
This is the formula: Plowback Ratio = (Net Income – Dividends) / Net Income.
Price-earnings ratio
This is the popular price-earnings ratio, one of the key ratios in value stock analysis. It is also known as the price multiple or the earnings multiple.
This is the formula for calculating it: P/E = Market Value per Share / Earnings per Share.
In this context, the price-earnings ratio shows how much investors are prepared to pay to earn dividends from a stock. For example, if a company is trading at a multiple of 20, it means investors are paying $20 to access each dollar of current profits.
Lowe pointed out that price-earnings comes in various configurations, the most important of which are:
- Trailing price-earnings, based on earnings for the past four quarters.
- Forward (or projected) price-earnings, based on expected profits for the next four quarters.
A higher price-earnings ratio suggests the market has high revenue growth expectations, and a lower price-earnings ratio suggests it has lower expectations. However, this measure is not enough by itself to value a company, rather it is one of many that might be used together.
This metric is most useful for comparing stocks within one sector or industry because all companies in it should have comparable methods of generating revenue. Comparing price-earnings ratios across industries or sectors produces misleading results.
Return on equity
Often referred to as ROE, the formula of this metric is: ROE = Net Income / Average Shareholder Equity.
It is important because it tells investors how much they are getting back, in dividends and retained earnings, from the capital they invested in a company. Again, it should be used within industries rather than across them.
We should also remember that comparisons can be misleading if we compare the ROEs of companies that pay high dividends against companies paying low dividends.
For the shareholder equity section of the calculation, turn to the balance sheet. There, you will see the running balance of changes to assets and liabilities; to calculate ROE, use the average equity over 12 months. As a guideline to the strength of ROE, Lowe suggested a long-term average of 10% to 20% as “an ideal ratio.”
This measure can be used to obtain the future growth rate of a company by multiplying the ROE by the retention (plowback) ratio. Lowe provided these two examples:
- Company M has an ROE of 15% and it is retaining 70% of its net revenue.
- Company N has an ROE of 15% as well, but retained earnings of 90%.
Therefore:
- The growth rate of Company M is 15% (ROE) x 70% (retention ratio) = 10.5%.
- Company N’s growth rate is 15% (ROE) x 90% (retention ratio) = 13.5%.
When using ROE to help choose dividend stocks, it helps to know the averages within the sector you are analyzing. For example, utilities will likely generate a return on equity of 10% or less, while retail companies may go to 18% or higher in exceptional cases. The difference is accounted for by the size of the balance sheets in the two sectors. Utilities carry a lot on their balance sheets from big assets and debt, while retailers tend to have smaller balance sheet accounts.
As a general guideline, Lowe recommended targeting companies that have ROEs slightly above that of the peers in their industry.
Finally, he noted, “Analyzing the ROE of different companies can help you choose stock dividends, but you must be cautious in comparing companies who are not in the same sector and who have different strategies in issuing dividend payouts.”
Conclusion
In the second section of chapter two in “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” Lowe has explored four more key ratios.
These, plus the metrics reviewed in the first section, provide investors with a set of tools investors can use to assess the fundamental strength of stocks being considered for purchase.
Lowe concluded, “It will be easier for you to choose the stock dividends with more chances to provide you with a regular income if you know these terms, and what they mean in the stock market.”
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