Ratios | The Market Capitalist

The Uses and Limitations of Predictive Models

Posted on September 2, 2011 by Dominico Johnston Posted in Investing, Ratios 1 Comment

A few weeks ago I released on this site a “Stock Price Estimator.” The model is relatively simple in that it bases future stock price on a stock’s beta and projected index swings. A number of factors can cause the model to be misguided and downright wrong. As with any model, it’s important to understand its strengths and its weaknesses.

To learn about this models weaknesses (and conversely understand its strengths), I’d like to consider the social networking company QuePasa (QPSA). QPSA is a highly volatile tech stock that lives in the realm of new social media companies. It’s volatility creates an interesting situation, which makes for a good example in evaluating the limitations of the Stock Price Estimator model.

When evaluating the risk of a particular stock, one straight forward method is to look at the stock’s beta. A beta above 1 means more historic volatility in the stock than the overall market and less than one means a lower amount of volatility. When beta is quoted online, it is often done over a 5 year period and against the S&P 500. In the case of QPSA, it’s a small stock that does not fit the model of an S&P 500 type stock/company. Therefore, it’s important to know that you’re comparing against a somewhat similar index.

The index I selected to compare QPSA against was the Russell 2000. For one, QPSA recently joined the index and the index is built upon small companies that are growth oriented. The index contains companies that are much more akin to QPSA than the S&P500. (Actually, I should have compared it to one of the newly created social media indexes, but their historical track record is limited…that causes analysis problems.)

After compiling data for activity over a 5 year period for QPSA and the Russell 2000, I then calculated beta. It turned out that over a 5 year period, QPSA actually had a beta of .57. This means that it has almost 50% less volatile than the Russell 2000. This seemed odd to me since I have been watching QPSA for about a year now and know it can run up and fall back down fast. Therefore, I calculated beta based on a 1 year time frame. The beta now shown was 1.39. This is a significantly different picture.

What an investor must be aware of when referencing beta is the time frame which was used to calculate the figure, the index it is being compared against and whether or not the stock’s behavior over the time period considered has been relatively constant. In the case of QPSA some major changes in the company have caused investors to create much more activity within the stock. Therefore, its 5 year historic trend is no longer relevant. It must be understood in a shorter time period.

When using beta and market increase/decrease projections to estimate the future market price of a stock, it is vital that you understand the nature of the stock. Larger more stable companies are better suited to provide you with a more accurate predictive variable in terms of beta than small growth companies like QPSA.

The Stock Price Estimator is geared towards providing estimates on companies that are more set in their ways (highly correlated) with market movements than not. In the case of QPSA, it can cover a lot of ground in a positive or negative direction in a very short amount of time. A number of factors are causing this, which is beyond our discussion here. Yet, know that such activity make the beta less of a predictive variable because the index its based against even though similar in companies is not similar enough in price behavior.

Considering the Dividend Payout Ratio

Posted on August 26, 2011 by Dominico Johnston Posted in Investing, Ratios Leave a comment

A number of reasons exist as to why investors flock to stocks that pay a regular dividend. For investors with an inclination toward dividend stocks, the all-mighty dividend payout ratio exists to provide a reference point regarding historical financial performance verses historical dividend distribution (payout) information. The ratio is expressed as a percent and considers dividends paid out per share divided by earnings per share ($Dividends Per Share/$Earnings Per Share).

It’s always important to at least consider the dividend payout ratio when a company’s dividend payment is holding weight in your decision to invest in the company. When you see a company paying at, near or above 100% this could be a sign of trouble. Though not always the case, it’s at least a red flag. The dividend payout ratio provides a guidepost for investors to gauge the weight the company’s payout ratio is placing against the company’s earnings.

One way to further leverage the usefulness of the dividend payout ratio is to think of it as an axillary gauge. You can use the ratio to help better understand other information you’re seeing. How do you accomplish this feat?

Dividend investors generally enjoying seeing that the company they’re considering has a history of increasing dividend distributions. Such action is not only good because of increased payments for current shareholders, but also benefits owners because increases have the power to attract more prospective investors. In short, growing dividend payments draw investors like ants to sugar.

How, as a new investor in a company that regularly pays and has a history of growing their dividend, do you evaluate the soundness of the dividend and its future growth? A good start to providing an answer to both questions is through the dividend payout ratio. As a rule of thumb a company that has a payout ratio of around 50% or less is not likely to be financially stressing itself in maintaining its current dividend payout. Additionally, a company in such a position with a history of dividend increases is providing investors a signal that they have additional room to continue their historical dividend growth growth pattern.

A good example of what is discussed above is Chevron (CVX). Chevron’s last quarterly dividend increased from .72 to .78 cents per share (quarterly) and their dividend payout ratio is 26%. If you look back over the past 20 years you see that the company has a strong history of dividend payment increases. Though history doesn’t necessarily lead to a linear future, observing the low dividend payout ratio gives additional insurance to investors that the company is positioned in a way to continue their dividend growth pattern.

The dividend payout ratio is a simple but powerful ratio, especially for dividend focused investors. Remember to consider the ratio when evaluating the health of a dividend payment and its propensity to potentially be increased in the future.

When To Look At Operating Cash Flow

Posted on July 31, 2011 by Dominico Johnston Posted in Investing, Ratios, Valuation 1 Comment

Revenues and earnings are nice numbers to quote, but often free cash flow (FCF) is a more valuable number for investors when evaluating a business. FCF can be a very powerful tool when evaluating a business. One area where FCF can hamper one’s investment analysis is when a business engages in a major capital project. The capital expenditures will be taken from the FCF value and could possibly drop FCF significantly quarter from a previous quarter.

To work around this weakness of FCF evaluation, it is sometimes more applicable to look at a company’s operating cash flow (OCF). OCF does not take into account capital expenditures and thus will provide a clearer picture of any changes in cash from actual operations.

When a company is growing capital expenditures can be very high. Such activity will drive down FCF. Under the assumption that the capital expenditure are being spent wisely, you would not want to hold such actions against a company. Therefore, focus on OCF when you know new capital intensive projects are going on.

Stock Volatility, Market Timing & Limit Orders

Posted on July 9, 2011 by Dominico Johnston Posted in Investing, Ratios, Strategy 4 Comments

Investors often use limit orders to buy into stocks, but at what price do you set the limit order? This is a challenge for any investor. To help answer this question, a simple observation of the stock’s beta can be used to determine an entry price when buying a stock.

Beta is a measure of a stock’s volatility compared to the overall market (typically the S&P 500), yet investors do not often have a practical application of beta beyond observing whether the stock has been more or less volatile than the market historically. Beta can be helpful in a number of additional ways. Today I’d like to highlight a simple way beta can help guide you in determining an entry point when purchasing a stock.

Though I don’t consider myself someone who can time the overall market with superior accuracy, I do use limit orders when purchasing stocks. I understand that market volatility is always present and typically I can take advantage of a small swing in prices to buy a stock a little below the quoted priced I observe when I first decide I want X stock in my portfolio.

When considering how drastic the buy price my limit order should be set at compared to the current stock price, the stock’s beta can be used as a general reading on how much price fluctuation should be expected compared to the overall market. A beta below 1 and you have a stock with less volatility, above 1 and you have a stock with more volatility.

Once you’ve decided to purchase a stock and are attempting to determine an entry price to set, look at the beta. Is the figure below or above one? For this example we’ll say it’s 1.5. This means the stock historically has 50% more volatility than the market (S&P 500). In other words, if the market rises by 2%, you should expect a 3% rise in the stock’s value (2% * 1.5 = 3%).

If we have a general understanding of how a stock reacts to market movements, then we can determine a reasonable entry price based on our market forecast. Holding that the market will dip by 5% sometime within the next month means that I should epxect approxamently a 7.5% dip in my example stock’s price. If the stock is selling for $20 at the time of consideration, then I should set my buy limit order to execute somewhere around $18.50 ($20 – ($20*7.5%) = $18.50).

The difficulty with using this predictive framework is that you still are dependent on being able to read the market. Wanting to enter into a position within the next week means being able to accurately predict the market’s movement in the next week.

I am of the opinion that when you are less anxious to enter into a position, this strategy is more effective. Every few quarters you are almost guaranteed that a period of market weakness will exist and some decent amount of selling will occur. This will either be a temporary down-turn or the start of a larger trend. In either case, it’s a window where your limit order will have a greater probability to execute.

Lastly, if you’re basing an investment decision on a specific positive event that you anticipate happening soon or has just occurred, I do not think it is wise to bet on a market pull-back. If you have clearly identified a catalyst for the stock’s growth in the near-term, then you should act on the information.

A History of Rising Dividends Is Indicative of Company Success

Posted on June 27, 2011 by Dominico Johnston Posted in Dividends, Investing, Ratios, Strategy, Valuation Leave a comment

A couple weeks ago I wrote about the significance of the dividend growth rate for long-term investors. Since that time I’ve given more thought to the subject. It should not be forgotten that companies that are able to consistently raise their dividend distribution are demonstrating, through tangible actions, that their company is a success.

One area that new and experienced investors worry about is earnings. First, investors worry about positive earnings because we all want to be part of a company that is alive and not moving towards death. Second, we want to believe that the earnings we’re being told about are legitimate. Yes, the number looks great, but is it an accounting scheme or is this some oddity that we’re not aware of? No one wants to be deceived.

A company that has a history of growing its dividend yield has demonstrated growth and earnings legitimacy. If you’re looking at historical data to evaluate a company, a growing dividend is a very strong sign that the company has a business model that has been proven successful.

In my previous example I looked at Pepsi, which had an extensive track record of dividend increases. When a company is able to year over year boost its dividend distribution, it’s showing real performance. Sure dividend payments can be maintained and even grown for a short period, if a company has a large cash holding, but after a few years reality will set in. In such cases you may have a company with an enormous dividend yield based on its current offering price. Why would this be the case? It would be the case because its payout ratio indicates that the dividend it’s paying is unsustainable! Unsustainable dividends do not increase the demand for a stock.

Look at the World Wrestling Entertainment Company (WWE). The company’s payout ratio has for over a year has been astronomically high (near 300%). The earnings of the company have not been sufficient to cover the quarterly dividend distribution paid out (.36 per share). To continue the dividend payout the company’s founders reduced the dividend amount paid to their class B shares and reallocated the dividend funds to the class A shares. This worked out great for a while, but when you’re not bringing in enough money, eventually the cosmetics ware off. The most recent quarterly dividend payment from the WWE declined from .36 per share to .12 per share.

What is stated above may sound confusing, yet it’s not. When earnings come out you will typically see in a press release a figure quoted saying something like, “…in the 3rd Quarter X company earned .xx cents per share.” Okay, great information. Now, go and look at what they have historically paid per quarter as a dividend. Is the amount paid per quarter as a dividend more or less than the earnings per share? If the earnings are less than the dividend a red flag should go up.

I know a lot a investors have a fear about the legitimacy of companies for sale on the public market. To a certain extent this fear is healthy. One way to help negate such fear is to fish in the waters of companies that have a track record of increasing their dividend payments. The longer the track record typically the better, but if I was pushed to say, I’d go with 5 years or more of annual increases to feel pretty comfortable with the legitimacy of a company’s dividend growth.

The simplest answer I could give someone if I was asked, “How do you know X company is legitimate?” would be to say “X company has increased its dividend distribution for Y years now.” Certainly there are other things that need to be evaluated when considering buying a company, but if you want something quick and dirty; look at the dividend track record and determine where it shows growth or not.

Note: If you’re looking at companies that do not pay dividends this obviously will not work.

Disclosure: No Position

Behind The Dividend Curtain – Dividend Payout Ratio

Posted on June 1, 2011 by Dominico Johnston Posted in Dividends, Investing, Ratios, Risk 1 Comment

I’ve often made the point that one argument for owning stocks that pay a dividend is that, “at least you know the company is making money.” In many cases this is the case, but in some cases it’s not quite true. All investors seeking a dividend yield need to make sure to look past the dividend and to the dividend payout ratio to gauge the heath of a company’s dividend distribution.

The dividend payout ratio is how much, in percent, the company is paying out in dividends compared to its earnings. If you were write this as a formula it would like like…

Dividend Payout Ratio = Dividend Payout Per Share / Earnings Per Share

The easiest way to determine the payout ratio is to visit Yahoo! Finance, select “Key Statistics” and scroll down until you find a section titled “Dividends and Splits.” The section will contain a percentage to the right of the “Payout Ratio.” If a company doesn’t issue a dividend, then you’re not going to see a percentage. For example, Altria (MO) currently has a payout ratio of 77%….they pay a regular dividend.

You can also look at actual dividend distributions and calculate it against earnings per share based on the same time-frame for both figures. It’s not the most difficult calculation in the world, but clicking 3 times is easier and faster….

What you need to keep in mind when investing is that even when a company has consistently paid a dividend for X number of years or quarters, their track record is at risk if they’re near, at, or over 100% in terms of their payout ratio. For instance, using a stock pile of cash for a dividend distribution might be fine, if it’s a one time special distribution, but if it’s being used to prop a regular dividend payment, then you’re dealing with an unsustainable situation. If a company payout ratio is at 98%, then a small margin of error exists before the dividend will be thrown over 100%.

If you’re seeing extremely high dividend payout ratio figures, you might want to dig deeper to see what the company is up to. For instance when I see MO paying out 77% of earnings as dividends, it doesn’t concern me much. Yes, they’re retaining less than 25% of their earnings for expansion or other endeavors, but they’re in a business that is established and stable. That makes sense to me.

Make sure to check the payout ratio when investing in high yield stocks. You do not want to have a false sense of security. Again, risk matters when investing.

What a long investor needs to know about short positions

Posted on March 20, 2011 by Dominico Johnston Posted in Investing, Ratios, Risk, Strategy Leave a comment

If you’re going long on a stock, then it is wise of you to see what the short position in the stock looks like. As you know, shorts make money when a stock falls in price and longs make money when the stock price rises. When you look to invest in a company, it is wise to look at the information typically provided about the stock’s short positions.

The process of short selling is different than buying a stock. Short sellers do not own the shares they are buying. Selling short places the short seller in a contract with another party (typically the broker) to be able to buy X stock at a specific price at a future point in time. For example, if a stock is trading at $8 and I sell short, I am betting that the stock will decease in price. If the stock falls to $5 then I will close my position and thus buy the stock for $5. I will have a $3 profit.

To actually sell short you will need a margin account. If the stock’s price rises, then short will eventually be subject to a margin call. Margin calls happen when an accounts value depreciates to the point where the broker requires additional funds be deposited to maintain compliance. In these case, short sells may close out their positions to satisfy the margin call.

When a stock with a heavy amount of short interest starts moving north, then margin calls will eventually occur. If the stock’s price moves north fast, it can cause what is terms a short squeeze. The short squeeze happens because of a lack of supply and an excess demand for a stock. Part of this process is helped along by the fact that short sellers are having to buy the stock when they cover their position. Therefore, you not only have regular traders demanding the stock, but you have short sellers adding to the fire.

If you’re looking to get a sense of how strong the short interest is in a stock, I would refer you to Yahoo! Finance’s Key Statistics section. It can be found within the information presented per each stock.

Short Interest Ratio (Days to Cover) = Current short interest / Average Daily Volume

As you see in the example above the stock has a short interest ratio of 2.10 days. Therefore, it would take over 2 days of trading, based on the stock’s average volume, to work through the shares held short.

Remember it’s not by accident that a stock has a high or low short interest. If you find yourself being drawn toward a stock with a lot of short positions, make sure that you understand why so many investors are short in the stock. A large short interest in a stock isn’t something that should automatically scare you away from an investment, but it should serve as a warning sign.

Should Young Investors Stay Away From Dividend Paying Stocks?

Posted on December 5, 2010 by Dominico Johnston Posted in Dividends, Investing, Ratios, Retirement, Risk, Saving, Speculation, Stock Ownership, Strategy 1 Comment

As a young investor, it is often the case that you hear or read about the need for your demographic to focus on growth stocks rather than value stocks. Thus, the message implies that young investors should stay away from high dividend yielding stocks (these stocks are almost always value stocks). Is this common knowledge a good investment strategy for young investors?

My experience as an investor (over 10 years now), leads to to believe that investing in high yielding dividend stocks can be a very smart and sound strategy for young investors. Often high yielding stocks are seen more as a defensive position than offensive, but this is not always the case. Often paying a sizable dividend is only part of their return on investment story.

Placing a heavy emphasis on growth stocks for young investors can open an investor up to a a significant amount of risk. When the risk taken is not in favor of the investor, recovering from the loss incurred will always take more energy to get back to par compared to the initial fall. (Classic example – Invest $100 then have a 50% drop in investment value = Account value of $50. To get back to $100 you must now find an investment that will double in value.)

The argument for investing in growth (higher risk) investments when your young is that any negative consequences from the excess risk you take will have a long period of time to work themselves out (recover from your losses). It’s assumed that not all growth investments will turn south. Therefore, given your time-frame, you should be able to capitalize on growth stocks that do succeed, which will more than negate the losses incurred from your other growth investments.

I believe a better strategy in today’s market exists for young investors. I do not have a study to point to. I am relying on experience and logic. My claim is that young investors in general should focus more on the following stock characteristics when developing a portfolio:

High dividend yield (in today’s market I would think +4%).
- The size of the yield will be a factor in attracting investors to the stock based on the dividend yield alone. This is largely to be seen in this strategy as a defensive mechanism. A decline in stock price will cause the stock to be more attractive to new investors based on the larger dividend yield they will realize by purchasing the stock at a lower price (payout rate to price.)

History of dividend payment growth (Think multiple years of history on this point. This also should (not always) help solve the question of whether the company can maintain their payment rate.)
- Showing a history of dividend payments speaks to the validity and viability of a company’s business model. Since this is historical information, you must also consider if anything might occur in the future to change the company’s ability to succeed.
- Historical dividend payment growth will not only cause you as an investor to realize a higher dividend yield, but it will also put pressure on the stock’s price to rise. As the yield rises, this will entice more investors to buy the stock (greater demand).

A position in an emerging market (think countries) or industry. (This implies that though the company might be of the value stock persuasion, it still has room to grow.)
- With a successful product or service coupled with a position in an emerging market or industry, the company should be able to show investors greater value. With value comes valuation and higher valuations mean better (greater) stock price appreciation for investors.
- As a young investor, I understand and agree with the need for capturing companies that are growing. The caveat is that you do not necessarily need to flock to pure growth companies to benefit from this point.

What are some examples of stocks that would mesh well with this strategy?

Telefonica (TEF) – Provides fixed and mobile telephony services primarily in Spain, rest of Europe, and Latin America.

Sasol (SSL) – An integrated energy and chemical company operating out of South Africa.

Line (LINE) – An independent oil and natural gas company, engages in the development and acquisition of gas and oil properties in the United States.

Energy Transfer Partners (ETP) – Engages in the natural gas midstream, and intrastate transportation and storage businesses in the United States.

Verizon (VZ) – Provides communication services in the United States and internationally.

BCE, Inc. (BCE) – Provides a suite of communication services to residential and business customers primarily in Canada.

Bottom line – Do not become obsessed with growth stocks. You can get as good or better returns with less risk if you look towards value companies that are paying strong dividends. Simply because a company pays a sizable dividend, does not mean that its share price is going to grow minimally in the future. Consider how this strategy might work for you and do your research. Again, this is not to stay young investors should run from growth stocks, but they should not shun other opportunities because they have been told more than enough times that they should embrace stocks that are only growth oriented.

Screening for Lucrative Investments

Posted on June 28, 2010 by Dominico Johnston Posted in Dividends, Investing, Ratios, Risk, Stock Ownership, Strategy 3 Comments

Screening for Lucrative Investments

Using a stock screener can be an effective way to screen for specific investment characteristics you desire or to simply identify new companies that you are unfamiliar with. To illustrate my point, I’ve used a screen to identify a number of stocks that are less volatile than the market, have shown constant earnings growth and have healthy dividend payouts. Below you will see the criteria I used. Click on the images below to see the results.

Stock Screen (via Scottrade on 6/27/10):

Beta less than S&P 500
Earnings Per Share (EPS) Annual Growth
- Current fiscal year – positive
- Next fiscal year – positive
Earnings – Greater than 4 consecutive non-negative quarters.
Positive dividend growth rate over the past 5 years.
Current dividend yield is between 6%-8%

To use Yahoo!’s screener click here.

Results

Results – Additional performance data…

How much of a bonus should you expect from taking on more risk?

Posted on April 15, 2010 by Dominico Johnston Posted in Interest Rates, Investing, Ratios, Risk, Stock Ownership, Strategy 1 Comment

CAPM – Capital Asset Pricing Model

CAPM claims that the expected return on a security (stock, fund…) is the risk free rate of money plus the investment’s risk premium.

CAPM = Risk Free Rate + Beta*(Expected Market Return – Risk Free Rate)

Risk Free Rate – Typically the going rate on a Treasury Bill is used…The idea here is that there is a time value of money. Simply by saving you will earn X%.

Expected Market Return – Typically this is the S&P500, but if you can identify the rate of return that is a better representation of your asset’s class, then you should use that expected return. For example, if I held an ETF that was based of all Brazilian stocks, I would want to find the expected return on a Brazilian index (Brazil’s main index is the BOVESPA).

Expected return is most likely going to come from a historical average of returns from the index (market).

Beta is an attempt to capture the greater or less risk a investment has compared to the market. Click Here to watch my video discussing beta.

Bottom Line - When you need to estimate what return on investment you should expect from a stock or fund you hold, the CAPM model is a quick and easy way to get a rough estimate. It’s not the best model in the world, but it is simple, easy to use and effective at providing an understanding of the premium you should receive from the risk you’re taking.