How to select a stock- Part V- Retained Earnings and Dividend Income

When you are thinking about investing in a company by owning its common stock, you need to see whether the company is using the profit generated in the best possible manner. There are two ways in which a company can make use of its earnings- return a part of the profits to its shareholders by paying dividend or use the earnings profitably to grow the earnings of the future.

Different companies use different ways of sharing wealth with their shareholders. One company might choose to pay a handsome dividend to their shareholders every year. Another company might decide to use the whole earning for investing in future growth and pay nothing to its shareholders. A third company may choose to pay a relatively small amount as dividend and invest the remaining amount in the business. Here, one could wonder how a beginner could decide which company is a better investment.

You should ask a question- if the company decides to keep the profits with itself, will it be able to generate a better rate of return on retained earnings than the return you would have got by investing it in some other opportunities available with you. If the company can do a better job with the retained earnings than you can in terms of generating a good rate of return, it should retain the earnings. Otherwise it should pay dividend to investors.

You can assess a company’s capability of generating superior returns by looking at the history of earning growth. If the growth in earnings in the past has been superior, you can trust the management with the retained earnings. If there is no history to look through, you should try to understand where the management is trying to invest in future. If you believe that the management is pursuing a worthwhile investment opportunity and can generate a good return reliably, you can trust the management with the retained earnings.

You should consider another factor in your analysis. If the company is giving you dividend, you have got money in your hands and you can earn real return on it by keeping in a safe investment opportunity. However, if you trust a company with retained earnings, there is a possibility that the company may not be able to give you superior returns in future. To compensate for this risk, ideally, the future earning prospects with retained earnings should far outweigh the earnings you can achieve yourself.

You will find that many companies pursuing growth opportunities are not paying dividends to shareholders. Similarly, many companies have matured in their earnings and are generating cash flow on consistent basis have been paying handsome dividends to their shareholders. These companies may not be having growth opportunities that can justify the use of earnings. Which companies you want to invest in depends on your personal judgment of the growth opportunities and your own ability to generate returns on dividend income. If you are in doubt, perhaps you should opt for the safety of dividend income rather than the probability of expected future earnings.

We have two more topics to cover in this series of ‘how to select a stock for investing’. Watch out for the next post in this series next week.

How to Select a Stock- Part IV- Financial Stability

In this post we will try to learn how we can ensure that the money we are going to invest in a company doesn’t go down the drain. Essentially, we will try to evaluate the intrinsic financial soundness of the company and understand the financial ratios or filters that we need to apply to remove risky companies from our consideration set.

Debt to Equity Ratio: Ideally, debt should not account for more than 50% of the total capital of the company. If the debt is more than 50% of the total capital, the company’s survival might be at risk.

Ratio of earning to fixed charges: The company should be at least able to cover its interest charges many times over. If the earnings are not covering its interest costs, it will have to borrow more to pay its interest- a situation that’s not sustainable for long term. Such companies might be very risky even if their long-term growth prospects are promising.

Current Ratio: Current ratio measures a company’s ability to pay off its short-term liabilities. It’s the ratio between the current assets (cash and other assets like inventory or receivables that can be converted into cash within a year) and the current liabilities (short term loans, accounts payable and other obligations that need to be paid within a year) of the company. Ideally, the current ratio should be at least 1.5 for a company. If the ratio approaches 1, you should be seriously concerned and look for more details on how the company is going to meet its obligations.

Long Term debt: The long term debt of a company should not exceed its working capital (Current Assets- Current Liabilities). This is a measure of the company’s ability to meet its long-term obligations with ease.

Size of the company: The bigger the size of the company, the safer it will be for you to invest in it considering all other things equal. The bigger companies have grown big because they have done well in the past. By definition, they should have more share of the business than their competitors and should be generating more cash.

While I have talked about various ratios in this post, I would like to emphasize that these ratios are not cast in stone for all companies and all industries. The recommended values ideally apply to majority of the industrial companies and can vary across industries. The recommended ratio values will help you stay in the safe territory while investing in stocks. Even in the safe territory, you will find enough number of companies you will be able to choose from for investment purposes. Hence, it will serve you well if you stay in the safer side of these ratios. Of course, the final call is yours based on your judgment and experience.

How to Select a Stock- Part III- Earning Record

When you are investing in the stock of a company, you need to understand the past earning record of the company. The objective should be to avoid the companies that have been losing money from your consideration set.

Grab last five- ten years annual reports of the company you are researching and go through them. If you are not able to get the annual reports, with a little research on the internet, you will find many sources where you can get last ten years earning record of all listed companies.

The company should have a consistent record of positive earnings for the last ten years. Many companies are able to give one or two years of good performance, and then they start giving erratic performance. Do not trust these companies with your money.

Consistent record of positive earning is a necessary condition but not necessarily a sufficient one for you to trust a company with your money. Ideally, a company should be considered only if it has been growing its earnings over the last ten years. Adding this filter will help you make your consideration set a lot safer.

Another thing to look for in a company’s past performance is the cash it is generating from operating activities. You will get these details in the Cash flow statement of the company. There are three heads of cash flow- Operating Activities, Financing Activities and Investing Activities. Cash flow from the operating activities is the most important cash flow component. This is the actual cash the company is generating from its business. Cash flow from investing activities is the cash flow from investment in financial markets or the cash consumed by investment in capital assets such as machinery, plant, etc. Cash flow from financing activities is the cash flow resulting from issuing stock dividends, taking or paying debt and issuing stocks. If a company is not able to fund its growth from the cash it generates from its business, and is instead relying on loan, it may not be a great thing. Of course, if a company is in its early stages, it may have to fund its growth through loans or issuance of stocks. However, growth funded through cash generated from operating activities is a lot safer than the growth funded through cash generated from financing activities. Here, you need to take a call based on your own judgment of the situation.

Understanding the stability and growth of earnings of companies helps you wean out the losers from your list of stocks to invest in and ensures that you are not investing in stocks that may bleed you later.

This is it for today..

How to Select a Stock - Part II- Success Levers

In my previous post I tried to explain how you could understand a business. The next step is to research a company and try to figure out whether its stock can be a good investment bet or not.

I am trying to stay away from giving specific examples, as I don’t want to bias you towards or against any specific stocks. Secondly, specific stocks from a geography may not make sense to readers from another geography. This makes my job a bit tougher as specific examples aid a lot in understanding a concept. But I shall try and make my posts as simple to understand as possible.

First of all, you need to understand what differentiates the company you are researching from its competitors. There are various levers of attracting customers that an organization can use to grow its revenue and profits- brand, research and development, customer service, cost advantage, economy of scale, efficient operations, etc. You need to understand which of these levers a company is using and how successfully.

If the company is using operational efficiency, cost advantage or economy of scale as its lever, it is going to attract customers who are cost conscious. Hence, it will be extremely important for the company to be able to stay at the forefront of operational efficiency by investing in its supply chain management, adopting new processes and keeping its cost of production or service low. You need to ask whether the company will be able to maintain its lead over its competitors by investing in the necessary upgrades or initiatives. This lever gives advantage to a company but requires them to continuously work hard and stay ahead of the competition.

If the company is using customer service and experience as its success lever, you need to understand the company’s capability in maintaining the loyalty of its customers by providing excellent customer experience every time a customer interacts with it. Generally, this lever is very strong and provides a long term advantage to the company as the customers start bonding with the company and don’t leave it until the company gives them strong reasons to defect.

Research and development provides another success lever to companies. Many product companies use this lever to create loyalty amongst customers. These companies focus a lot on creating a culture of innovation within the organization. However, you should be able to ascertain whether the company in question is designing products or conducting research keeping the interests of the customers in mind. Many companies get trapped in new technology development without knowing how they are going to use it. This proves to be fatal for them. Research and Development lever can be used successfully by continuously engaging in customer focused research and product development.

At the end of this analysis, you should be able to answer this question- if a customer has to buy a product or service, which is also offered by the company you are researching, will he buy it from the company? If yes, why? And what will make him coming back?

If your answers to these questions are in the favor of the company you are researching, you have found a potential winner. But this is not the end of your quest for finding a winning stock. There are a few more things you need to do. I will cover them in my coming posts. If you have any queries regarding this post, let me know.