Dividend Cover and Payout Ratio

The dividend cover ratio gives an idea to external parties about the results of operation of a company that might drop leaving the amount of dividends to be paid from the result of the year unchanged or reduced.

Dividend cover ratio that is more than 1.0 (> 1.0) indicates that the ordinary dividends should be paid our for the year.

However, dividend cover ratio that is less then 1.0 (< 1.0) shows that the company is not earning enough profits to pay out as dividends. Therefore, the company is using past retained earnings to fund the dividends payment. This may be a danger sign for potential investors.

The dividend cover ratio is just the opposite of the payout ratio.

Payout ratio that is more than 1.0 (> 1.0) implies that retained earnings are being used to payout as dividends.

Ways to Evaluate A Company

Some investors may be wondering, between return on equity (ROE) and price earnings ratio (PER), which method is more suitable to value a company.

Warren Buffett said a good business should be able to achieve good ROE without employing high debts. Companies with high gearing are vulnerable to financial risk during the economic downturn and high interest rate environment. 

Besides, any future investment plans should be funded by internally generated cash flow without having to call on shareholders to contribute. Unless the return generated from the shareholders’ money is greater than ROE, it will show lower shareholders’ returns as a result of the enlarged share capital.

One of the biggest weaknesses in ROE method is that it does not take into account the current price of a share. A good company may show high ROE but its market price may be reaching all-time high. Hence, any investors who are solely dependent on the ROE method may be purchasing a stock at a very high price, which does not provide investors with margin on safety (MOS).

PER is defined as the market price of a company divided by its earnings per share (EPS). The principle behind this method is the concept of payback period. This ratio tells us how many times the price is greater than the annual earnings of a share. For example, Company A is currently selling at a PER of 15 times. This means that it takes 15 years for an investor to get back his returns

through the company’s annual earnings, assuming that the company will produce the same EPS during that period. 

Select stocks with low PER, but ?

First, we have to understand what causes a company stock to be sold at a low PER, where the market price is lower relative to its earnings. An unduly low price for a company may be due to the market’s failure to recognize its true earnings picture and potential. In this case, the company’s PER is usually far below the market PER. 

However, not all stocks with low PER imply good value for investing. As mentioned earlier, sometimes the cheap valuation may be a true reflection of certain negative aspects of the company, for example, poor corporate governance, high gearing, uncertainty of future earnings and or it is facing litigation.

However, as a result of asymmetric information, not all investors are fully aware of the market’s worries. Hence, analysts with the necessary knowledge, skills and market information play a very critical role in helping investors to analyze companies in detail and identifying those that are truly undervalued based on fundamentals.

Debt to Equity Ratio Formula

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It indicates what proportion of equity and debt the company is using to finance its assets.

 

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate more earnings than it would have without this outside financing. If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same amount of shareholders. However, the cost of this debt financing may outweigh the return that the company generates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of under 0.5.

Debt to Equity Ratio

The debt/equity ratio is important to investors because the more outstanding debt a company has, the greater the proportion of earnings it must use to make payments on the interest and principal. This of course reduces the amount of capital available to help the business grow, to do research, to develop a marketing plan or even to pay dividends to the shareholders.

When a corporation takes on debt, it is locked into making fixed payments, typically twice a year. If it has a bad year, it may not generate enough cash flow to cover the interest payments in which case it must consider selling an asset, raising more money or if the situation persists, possibly declaring bankruptcy.

HIGH vs. LOW RATIOS

A high debt/equity ratio means that the company has been "aggressive" in financing its growth with debt and that it is carrying a sizable amount of interest expense.

A ratio greater than 1 means assets are mainly financed with debt; a ratio less than one means equity provides the majority of the financing.

Ideally, you want to invest in a company where the total debt to equity figure is low -- below .50. However, there are many well-run companies that have a ratio of 1 or even higher. But if the debt-equity ratio surpasses 2, be extremely cautious. Make certain the company can handle its interest payments, and that it has a strong cash flow.

CAUTION: Some companies shift their financing needs to short-term obligations. This makes their long-term debt ratio look better. But, of course, the overall leverage of the firm is the same. Therefore, I recommend that you check the TOTAL DEBT RATIO because this figure includes both short and long term debt.

Book value

What is book value?

The book value of a company is generally considered its net worth; the book value per share would be the net worth of a company divided by the number of shares outstanding.

Benjamin Graham definitions

There is a need, in considering the book value of a company share, to know what certain terms mean - and who better to explain them than the doyen of investment analysis, Benjamin Graham. His definitions are:

Tangible assets: Assets either physical or financial in character eg plant, inventory, cash, receivables, investments.

Intangible assets: Assets which are neither physical nor financial in character. Include patents, trademarks, copyrights, franchises, good will, leaseholds and such deferred charges as unamortized bond discount.

Graham took the view in Security Analysis that intangible assets should not be taken into account when calculating book value; hence, in this sense, book value per share would be the same as net tangible assets per share (NTA) as opposed to net assets per share (NA).

So, the assets of a company can be either tangible or intangible and, on this point, Benjamin Graham and Warren Buffett appear to have differences in importance.

The Benjamin Graham approach to book value

Graham clearly considered book value an important factor in assessing share investment. He did not include intangibles in his calculations of book value and was attracted towards companies that sold at below their book value. This was a big factor in making a judgment about the company as an investment. He said this:

‘It is an almost unbelievable fact that Wall Street never asks, "How much is the business selling for?". Yet this should be the first question in considering a stock purchase.

'If a business man were offered a 5% interest in some concern for $10,000, his first mental process would be to multiply the asked price by 20 and thus establish a proposed value of $200,000 for the entire undertaking. The rest of his calculation would turn about whether the business was a "good buy" at $200,000.’

Graham did however acknowledge that under ‘modern conditions’ intangibles were just as much an asset as tangibles, assuming of course that a proper value could be determined. They could, in some situations, even be superior assets.

What Benjamin Graham said about intangible assets?

‘Earnings based on these intangibles [e.g. goodwill] may be even less vulnerable to competition than those which require only a cash investment in productive facilities.

'Furthermore, when conditions are favorable, the enterprise with the relatively small capital investment is likely to show a more rapid rate of growth.

Ordinarily it can expand its sales and profits at slight expense and therefore more rapidly and profitably for its stockholders than a business requiring a large plant investment per dollar of sales.’ Emphasis added.

How Warren Buffett looks at intangible assets

This last comment of Graham has importance for Warren Buffett, who seems to really like companies with valuable, and sometimes irreplaceable, goodwill. To Warren Buffett, it is this intangible good will, an asset that continually produces profits without the need to spend money on maintenance, upgrading or replacement that adds value to a company. Consider what it is that is most important in producing profits for Coca Cola: its name and recipe, or the various factories that produce the drink.

Warren Buffett on economic goodwill

This is what Warren Buffett calls economic good will which he explained in 1983 like this:

‘[B]usinesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.’

Using by analogy, one of the favorite examples of Warren Buffett, take two separate companies. Company A has a net worth of $100,000, $40,000 of which is net tangible assets and $60,000 of which is intangible (brand name, goodwill, patents etc). Company B has the same net worth but $90,000 its assets are tangible. Each company earns $10,000 a year.

So Company A is earning $10,000 from tangible assets of $40,000 and Company B is earning $10,000 from tangible assets of $90,000.

If both companies wanted to double earnings, they might have to double their investment in tangible assets. For Company A to do this, it would have to spend $40,000 to add $10,000 of earnings. For Company B to do this, it would have to spend another $90,000 to add $10,000 to earnings. All other things being equal, Company A would have better future prospects of increase in real earnings than Company B.

The real profitability of a company

For these reasons, Warren Buffett has said that, in calculating the real profitability of a company, there should be no amortization of economic goodwill. Does the Gillette brand name actually decrease in value each year? Of course not.

The thoughts of both Graham and Warren Buffett are worth consideration. Book value is another ingredient in the investment equation.