Reading through financial statements – How to judge a company and its future dividend

By: ispeculatornew
Date posted: 01.25.2011 (5:00 am) | Write a Comment  (0 Comments)

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A few months ago, we did a survey for all of our newsletter members (it’s free to join) for subjects that they wanted to have discussed. Many of those are being discussed in our weekly newsletter but we are inserting some of them on the blog as well. In that spirit, we wanted to answer a question about finding solid dividend companies by looking at the financial statements of companies. It’s a complex question of course and each investor would probably have slightly different ways of looking at it. I did discuss the 20 things that I look for in dividend stocks and that certainly gives a hint but I will try to give an even clearer picture in this post. There is no perfect method though and I am more than happy to hear additional ideas or to discuss future ones.

In my opinion, what I look for in a company at the most simple form is:

1-Existing dividend yield of at least 1-2%
2-Moderate to high and sustained dividend growth

The first point is not the most important and it’s usually the easiest to verify. You can simply take a look at the current payout and determine if it fits the overall criteria.

The more difficult part is the 2nd statement. Let’s take a look at each part of the section:

-Moderate to high dividend growth: Personally, I like to see a stock that can increase its payout by 5% or so every year for the medium to long term future. How can a company increase its dividend payout? Let’s take a quick look:

Dividend = Earnings x Payout Ratio

In order to increase a dividend yield, a company must be able to increase one or both of these. Because of that the payout ratio is important. A company that is paying over 100% of its earnings in dividends will not be able to sustain this unless its earnings increase. It is far from ideal. As well, while a company could be increasing its dividend through an increased payout ratio, it’s difficult to do that for a long period of time. Therefore, the key component is earnings growth.

Earnings = Revenues x Profit Margin

Obviously, a company can increase profits over time by improving its margins. That can be done in many different ways such as increasing prices, diminishing costs through productivity gains, etc. However, like the payout ratio, it can only be done for so long. Increasing margins is important but it’s not sustainable over 20 years.

Therefore, what is the most critical in my opinion when looking at a long term dividend stock? Revenues growth!! Take a look at a company like Proctor & Gamble (PG) which has increased dividends for a very long time, and how its revenues also increased.

The two are very much tied up together as you would expect.

So in my opinion, the most important number is revenues growth. It’s important to understand:

-Where do revenues come from?
-How much competition exists?
-Is the market still growing?
-Do you expect the company to maintain its growth over 5, 10 or even 20 years?

All of these questions are critical and the answers will not necessarily be found in the the financial statements but you should be able to get a much better idea by listening to an earnings call or reading an annual report. Numbers that are of importance would also include the debt ratio (companies with a lot of debt will have more long term problems to keep up the growth) but also market share, payout ratio, etc.You also want a company that is reinvesting for the long term through asset purchases, R&D, hiring, etc.

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