My Initial Evaluation Methodology.Posted: September 22, 2012
There isn’t one sure way of evaluating companies, and everybody’s method will depend on factors specific to their situation: time horizon, risk tolerance, experience, knowledge of the industry, etc. I thought it would be a useful exercise to document what I look for in a company when I am evaluating it to see if it would be a worthwhile addition to my portfolio. To that end, here are the key factors I look at.
- Earnings per Share
Commonly referred to as EPS, this is an indicator of how much of the net income is left to distribute to share holders for a given period. EPS is calculated as the total net earnings, divided by the total number of common shares outstanding. In addition to EPS, there is another variant called diluted EPS, which adjusts net income and total shares outstanding by factoring in events such as conversion of warrants, options, convertible shares, convertible bonds, etc. In short, the number of shares outstanding for diluted EPS is the theoretical number of shares outstanding if anything that couldbe converted to a common share, was converted, during the period.Typically I would want to see a rising EPS, with some caveats.
One must be sure to to understand why EPS is rising. For example, since EPS is net income divided by number of shares outstanding, reducing the number of shares outstanding is one way to boost the EPS. If a company reduces the total number of shares outstanding through a share buyback program which uses up free cash from the balance sheet, this is typically a good thing. However, if a company takes out a loan to repurchase shares, that may be a bad thing. EPS can also rise when net income rises, but there are different reasons net income may rise. For example, net income may rise because operating expenses have decreased, but operating expenses may have decreased because the company laid off half of its workforce; this may spell trouble for the comapny, and they are looking for ways to cut corners. But, cutting the workforce may not be a badthing, since the workforce may be cut due to increased operational efficiencies, so the firm simply doesn’t need the staff.In short, rising EPS is good, because it shows that year over year (YoY) the company is making more money. But, one must investigate the rise in EPS to ensure it isn’t rising at the expense of something else (pun intended).
As a dividend investor, the dividend is obviously the most important thing to look for; if the company were not paying a dividend, it wouldn’t even be on my radar.Typically a dividend should be rising over time, a topic which I will address in a future post.
- Dividend Payout Ratio (DPR)
The dividend payout ratio is the proportion of earnings (from EPS) that are paid out as dividends, and is reported as a percentage, calculated as Dividend/EPS. A typical company will have a dividend payout ratio that is less than 100%, but there are some types of companies where the dividend payout ratio is greater than 100%. Excluding those companies, the dividend payout ratio should be a number which is adequate for the industry, or the peers of the company being analyzed. A dividend payout ratio that is too high means that the company may be paying out too much of its dividend, leaving little cash for internal projects. A dividend payout ratio that is too low means that the company may be burning through too much cash internally, or may not be returning a fair portion of the earnings to the shareholders. I personally like to see a dividend payout ratio of less than or equal to 60%. Such a value provides enough of a cushion that a firm may still be able to pay out a dividend even when net income isn’t as strong as in previous periods. Firms such as those that weathered the recession of 2008 and still managed to increase their dividend would be good examples of firms that did not have a dividend payout ratio which was too aggressive, allowing them to continue to return value to shareholders even when sales were down.
- Share Price.
Of course, while dividend are great, one also would like the capital investment to increase over time, or at least stay in line with inflation. To that end, the share price of a firm should be rising over time. The actual growth rate of the share price is relative to the growth in the dividend itself. For example, a firm whose dividend rises YoY by only 1%, but whose share price increases by 4% per year, is better than a firm whose dividend yield rises 4% per year, but whose share price only rises 1% per year.
- Price to Earnings, Price to Book, and the P/E * P/BV Multiple.
- Free Cash Flow from Operations.
One often overlooked indicator is the free cash flow from operations, which is essentially how much literal cash changed hands as a result of the firms day to day business(es). Dividends are ultimately paid out in cash, and if the dividends paid in a given period outweigh the actual cash that was earned in the period (actual cash excludes items such as accounts receivables, which are obligations for customers to pay cash in the future), this indicates that the dividends may be being funded from another source, e.g. leverage (which would show up as cash flow from financing activities) or selling assets (which would show up as cash flow from investing activities). When a firm starts paying dividends from non-operating cash streams, that is a big warning sign that the dividend is likely not sustainable.
This last screen is one that I picked up from Benjamin Graham. Graham felt that the P/E of a stock (Price divided by EPS) should be less than 15, and that the price to book value (share price divided by the book value, where the book value is the equity (assets-liabilities) divided by the number of shares outstanding) ratio should be 1.5 or less, and combining these two numbers gives an upper limit of 22.5. Personally, I prefer an upper limit of 25, and this gives me some latitude with the P/E and P/BV. For example, even if the P/E is higher than 15, if the P/BV is extremely low, I would still consider the stock.
The point of this combined ratio is not to buy companies that are inherently overvalued. If a company sports a very high P/BV ratio, in theory, if the company were to be liquidated, the total assets remaining would not be sufficient to distribute to all of the shareholders. Likewise, if the P/E is very high, this means that the expectations of the companies future earnings as measured by the share price are extremely out of line with the share earnings themselves.
And there you have it. The above points are my initial screens, but I also like to dive into some of the other details as well. However, the above provides a good starting point to identify which companies warrant further analysis.