Finding companies that have staying power

Let’s face it. Capitalism is harshly competitive. Some companies just don’t survive. If you’re going to place your investment dollars in a company, you want to make sure it can endure. Investing in durable companies gives a fundamental analyst courage to be patient — even in a downturn and even if the stock is down — because there’s evidence the company can endure.

As a normal part of the ups and downs of business, or the business cycle, there will eventually be a downturn. It’s often during these tough times companies demonstrate their lasting power. Because many investors give up on companies when they’re down or out of favor, and prices fall, that can present tremendous opportunity to you as a fundamental analyst. If you take the time to find companies that are just down, and have the ability to recover, you can pick up good companies for low prices.

Typically, when you’re looking for companies that have the resources to survive, you want to consider some key elements.

Looking for a company on the rise

If there’s one thing many investors can agree on, it’s that they want a company they’re investing in to be stable, if not growing. Companies with growing earnings and revenue can be attractive investments if the price isn’t too high. Flip back to Chapter 8 to read about the PEG ratio if you want to remember how to see how much a company’s growth is worth.

Fundamental analysis can also be extremely helpful in pinpointing companies where the earnings and revenues are in an upswing. Some investors, called momentum investors, like to buy into companies when they’re reporting faster and faster growth. These investors are betting they can grab on to a company with lots of good things going for it. But even value investors, who try to buy stocks on the cheap, are betting that a company will eventually start to do better, and the stock will catch up.

Finding companies that are growing rapidly is usually done using trend analysis, which is described in detail in Chapter 17.

Betting on the brains behind the operation

When you invest in a company, you’re not just investing in its brands, products, and assets. You must have evidence that the management team is properly equipped to manage the company well to deliver outstanding results.

Return on equity and return on capital, both discussed in Chapter 8, are the best and quickest ways to figure out how well a company is managed.

Return on assets is another helpful tool for fundamental analysts to use to give management teams a report card. The measure tells you how much profit the company is generating from the assets it has under its control. Return on assets helps you see how well a company is running itself without any financial distortion caused by the use of debt. If you compare a company’s return on assets to that of its peers, using the same techniques applied to return on equity in Chapter 8, you get a good idea of how well the company is managing your money.

Fundamental analysts can dig even deeper by dissecting return on assets. But dissecting return on assets into parts can reveal even more about a company’s management. To show you want I mean, first consider the formula for return on assets:

Return on assets = Income ÷ Assets

Income, in this formula, means different things to different fundamental analysts. Some use net income, because it’s easily obtained from the income statement. Yet others use earnings before interest and taxes, or EBIT, instead of net income to measure return on assets. You can refresh your memory about the advantages and disadvantages of both net income and EBIT in Chapter 8.

Okay. I’ll stop talking about how great return on assets is and actually show you what I mean. Let’s try out the power of breaking return on assets apart by using an example: industrial company 3M in 2021. I’ll save you the trouble of going to the financial statements and pull all the data you need in Table 10-2.

For this example, we’ll make the return on assets formula a bit more precise. We will divide 3M’s income, or tax-adjusted EBIT, by its average assets.

You calculate average assets by adding 3M’s assets in 2021 to the assets in 2020 and dividing by 2.

Plugging in the numbers in Table 10-2, you determine 3M’s return on assets to be 10.3 percent:

Return on assets (0.103) = Tax-adjusted EBIT ($4,869) ÷ Average assets ($47,208)

You can convert return on assets into a percentage by multiplying the answer of the preceding equation by 100 to get 10.3 percent.

Presto! With just a bit of math, you have found how much profit 3M’s management is squeezing out of its assets. For every $100 in assets, 3M is driving $10.30 of profit. That is a solid return, compared with other industrial conglomerates. The average company in the miscellaneous manufacturing industries category was just 4.6 percent in 2021, says ReadyRatios.

It’s one thing to know 3M has a high return on assets for its industry. But fundamental analysis helps you figure out why with fairly granular precision. You can do this analysis by breaking return on assets into its pieces. Bear with me as I present to you yet another formula. It’s return on assets broken into its component parts:

Return on assets = Profit margin × Asset turnover

And let’s cut that formula down even further to say:

(Tax-adjusted EBIT ÷ Average assets) = (Tax-adjusted EBIT ÷ Revenue) × (Revenue ÷ Average assets)

Once your eyes stop glazing over, you’ll recognize the power of this formula. I’m just combining several concepts so you can see exactly what is driving 3M’s impressive return on assets. A company’s return on assets is a function of its profit margin and its asset turnover. A company’s profit margin is how much it keeps in profit from every $1 in sales, discussed at length in Chapter 5. And the asset turnover is how much revenue a company earns from its assets.

Breaking down the return on assets shows you the two levers a company can pull to boost its return on assets: profit margins and asset turnover.

When you plug the numbers from Table 10-2 into the formula, you can see that return on assets for 3M breaks into these pieces:

($4,869 ÷ $47,208) = ($4,869 ÷ $35,355) × ($35,355 ÷ $47,208)

I could have spared you from these formulas. But just as doing your own personal taxes helps you understand how your actions affect your tax bill, breaking down return on assets lets you see how a company’s management can boost returns to shareholders, which is of great importance in fundamental analysis.

Don’t just shake a CEO’s hand and decide to invest in the company because you like him. Give them a report card — by using the financial statements to break apart return on assets. Just know that when looking for management teams worth investing in, find those that are:

• Boosting their profit margins: Profit margins, however you measure them, are a key component to a company’s future. Either charging more for products or driving costs down can enhance a company’s return on assets.
• Putting their assets to full use: The more revenue a company can generate from its assets, the better the returns. Just having assets sitting around doing nothing will slow down asset turnover and impair return on assets.
• Doing everything simultaneously: Even a small improvement in profit margins and a modest improvement in asset use can have an explosive effect on a company’s return on assets. That’s who you want working for you.

Minding the earnings yield

There aren’t many things in life that are as useful upside down as they are right-side up. Many a child has shed a tear over an upside down ice-cream cone.

But the price-to-earnings ratio, or P-E, is one of the few things that can be of value upside down. In Chapter 8, you found how the P-E is a key tool to understand a stock’s valuation and whether it’s an attractive investment. When you flip the P-E ratio over, and look at the reciprocal, you get what’s called the earnings yield. While the P-E gets all the attention, the earnings yield can be easier for some to understand. The earnings yield tells you how much in earnings a company is generating for every dollar you invested.

Let’s keep things simple and use 3M’s net income during 2021 and stock price at the end of 2021 for an example. 3M’s stock ended the year at $177.63 a share, and the company reported diluted earnings per share of $10.12 a share (excluding one-time charges). Dividing 3M’s stock price by the diluted earnings per share, shows you the stock has a trailing P-E of 17.6 times. If you’d like to review how to calculate a P-E ratio, flip back to Chapter 8, where it’s described in detail.

But now, try instead dividing the diluted earnings per share by the stock price and multiplying by 100 to convert it into a fraction. Go ahead, it won’t hurt. You find out that the company is generating earnings of $5.70 on every $100 invested in it, or 5.7 percent.

The earnings yield is so useful because it puts the P-E into a form that is easily understood and compared with other investments competing for your dollars. For instance, if you could get 6 percent in interest from a savings account (highly unlikely in 2022 when you’d be lucky to get 2 percent) then the 5.7 percent earnings yield from 3M wouldn’t be all attractive. You could take less risk and get more return. You’ll want to make sure the extra risk is worth it, for instance, if you’re convinced the company’s earnings will skyrocket.

Breaking down some top reasons to say adios to a stock

There are many reasons why a fundamental analyst might decide to part with a stock. Here are some of the major ones:

• Decelerating earnings or revenue growth: When you start noticing a company’s growth is stalling out, that can be a warning sign of trouble. Flip ahead to Chapter 17 on ways to measure trends at a company.
• Deteriorating financial ratios: When companies start taking a dramatically longer time to collect cash from customers or pay their bills, that can tip you off to trouble. Check out Chapter 8 for more details on this.
• Poor corporate governance or questionable management: If the motives of a company’s executives are not in alignment with investors’, that can be a problem. Chapter 9 shows you how to do this analysis.
• Overvaluation: Even good companies can get overvalued. As hard as it is sometimes, you might be best off selling a stock when the company seems like it can do no wrong and the stock price is soaring to unsustainable heights. Remember the example of Cisco earlier in the chapter, when the company’s stock got ahead of itself a second time? There are many ways for a fundamental analyst to measure valuations. The earnings yield (discussed in the “Minding the earnings yield” section, earlier in this chapter) is one way; another is the dividend discount model, discussed in the “Using dividends to put a price tag on a company” section, later in this chapter. But don’t forget about the P-E and PEG, discussed in Chapter 8, and the discounted cash flow analysis covered in Chapter 11.
• Rising risk of default: If you have any questions at all whether a company can afford the interest on its debt, sell first and ask questions later. Perhaps the first way to sense this is by analyzing a company’s interest coverage ratio, as described in the section “Evaluating companies’ financial condition” in Chapter 8. You’ll also want to scour the annual report for the words going concern from the auditors. If the auditors are worried, you should be petrified. I show you where to look for this in Chapter 12.
• Chronically missing expectations: Wall Street analysts routinely forecast how much they expect a company to earn in a given quarter or year. Companies that miss these expectations are sometimes giving you a heads up that either the stock is too high or the company is struggling. You can read more about this in Chapter 14.
• Your appetite for risk has changed: Perhaps you have recently changed jobs or think you’ll need your money sooner than you’d thought. You might consider selling some of your smaller or more speculative stocks, because they tend to be riskier over time.

Why selling stocks everyone else wants can be profitable

Fundamental analysis is pretty logical — most of the time. But when you’re talking markets, or forums where people are using money to set prices on things, sometimes emotions can introduce some irrational events. Here’s one illogical truth of markets that drives some investors mad: Sometimes the best time to sell a stock is when it seems everyone else wants to buy it.

A good company’s stock may turn out to be a bad investment if you overpay for it.

There are a few telltale signs that show too many investors are piling into a stock, perhaps making it overvalued and a candidate to be sold, including:

• Inflated price-to-book ratio: The price-to-book ratio, described in Chapter 8, is your first tip-off when a stock is getting driven up too much. The ratio compares the stock price to the value of a company, according to the accountants. The most basic way to think of book value is the total of a company’s assets minus its liabilities. When you see a stock’s price-to-book pull ahead of its industry peers, you might consider selling.
• Lofty price-to-earnings ratio: Unfortunately, there’s no concrete definition of when a P-E is too high. But one thing’s for sure. When a company’s P-E gets high relative to the other stocks in the industry, you ought to be concerned and consider selling. Also, if the stock market’s P-E is 15 and your stock’s P-E is above 100, you might consider selling a bit.

Data have proven how investors are often best served avoiding the stocks other investors are clamoring to buy, and stick with the ones that are being largely ignored. It’s Wall Street’s version of the ugly duckling turning into the beautiful swan.

Growth stocks are the darlings of Wall Street everyone wants to own. Value stocks are the unpopular stocks investors won’t pay up for. Table 10-3, for instance, shows how growth stocks, those with the highest valuations, have performed worse than value stocks with low valuations and the market in general over the long term. It’s another reminder that when others are talking (or bragging) about a stock at a cocktail party, you might consider selling.

Isn’t that amazing! Value stocks — the ones that most investors don’t think are worth much — over the long haul have outperformed not just the market but the most prized growth stocks, too. It’s important to study the behavior of investments over the very long term because it removes short-term distortions when growth stocks or value stocks might be outperforming.

Calculating the dividend yield

Don’t think that dividends are these tiny payments that don’t add up to much. Dividend payments are a critical aspect of fundamental analysis because they are often a major piece of the return you get from stocks. More than a third of total returns from stocks between 2017 and 2021 came from dividends, as you can see in Table 10-5.

Even so, when you hear that Ford, for instance, pays a 15-cents-a-share quarterly dividend, it doesn’t tell you much, and it probably sounds puny. Sure, that means that you might expect to earn 60 cents a share in dividends in the year, but that’s about it.

That’s why the dividend yield is such a key aspect of fundamental analysis. The dividend yield tells you how much cash you’re getting in the form of dividends for every $1 you’ve entrusted to the company. If the stock price were to remain flat and do nothing, the dividend yield would be your investment return. The formula for dividend yield looks like this:

Dividend yield = Annual dividend ÷ Share price

Fundamental analysts measure the annual dividend in several different ways. Some add the actual dividends paid over the past year, while others annualize the current quarterly dividend, or convert the quarterly dividend into an annual one by multiplying by 4. When a company has recently cut its dividend, it’s best to use the annualized current dividend.

Using Ford in 2022 as an example:

Dividend yield = (Current quarterly dividend × 4) ÷ Share price × 100

Let’s put some real numbers against this formula. In August 2022, Ford was paying 15 cents a share as a dividend and the stock price was roughly $16. That means the dividend yield was 3.8 percent, measured this way:

3.8 = (0.15 × 4) ÷ 16 × 100

At 3.8 percent, Ford’s dividend yield was slightly higher than the S&P’s dividend at the time of 1.3 percent.

Knowing if you’re going to get the dividend

Investors who are investing in a company need to pay close attention to the timing of the dividends. Companies are meticulous about which shareholders receive the dividend, and there are several key dates to know about:

• Ex-dividend date: This is the date that you must already be a shareholder or buy the stock by in order to make sure you get the dividend.
• Date of record: This is the date that the company looks at its records to see who its shareholders are and determines who’s getting the dough. If you bought or own the stock by the ex-dividend date, you’ll be on the list on the date of record.
• Payable date: This is the date you actually get your dividend.

Making sure the company can afford the dividend

It might be tempting to look for stocks with the biggest dividend yields. Some investors get dollar signs in their eyes, thinking about dividends as an allowance for grown-ups. There’s just one problem, though. There’s no law saying a company must continue paying the dividend. And if the dividend gets cut, you may be sorely disappointed.

There’s no for-sure way to know whether a company will cut its dividend. However, there are some telltale signs. For instance, if you see a dividend yield creep dramatically above the average for the S&P 500, that can be a tip-off a cut could be on the way. Ford’s dividend yield before the January 2020 cut was 6.5 percent, definitely lofty when the average for the S&P 500 was 1.7 percent at the end of 2019, S&P says.

When you start seeing a company’s dividend yield creep up well above the rest of the market, that’s a signal to you that either the dividend yield is about to get cut or the company is in a deeply distressed situation. Keep in mind, though, dividend yields are best compared to like companies. Utilities and banks, for instance, have historically paid larger-than-average dividends and need to be compared to one another.

Some companies are just more into dividends, or their industries lend themselves to big dividends. That’s why just looking at the yield might not tip you off to a company that can’t afford its dividend anymore.

Fundamental analysts have a tool to help them determine when dividends are getting too high. This dividend payout ratio shows how affordable a dividend is to the company paying it. The formula is:

Dividend payout ratio = Annual dividend per share ÷ Diluted earnings per share × 100

To calculate Ford’s dividend payout ratio for 2021, for instance, divide the amount of money Ford paid out as dividends by its net income in the same year. Ford paid $403 million (or 10 cents a share) in dividends in 2021. You can get this number from the company’s financial statements. Divide the dividend payments by the company’s 2021 net income of $17.9.7 billion and multiply by 100 to arrive at 2.3 percent. In other words, Ford pays out 2.3 cents of every $1 in earnings as dividends. A 2 percent dividend payout ratio is very reasonable, as it leaves plenty of money for the company to invest in itself.

Investors need to be very suspicious when a dividend payout ratio gets to 100 percent or higher. That means the company is paying out every dime it has earned as a dividend. A dividend payout ratio that high might mean the company will not be able to increase the dividend or might have to cut it.

Some real-estate companies, including those structured as real-estate investment trusts or REITs, are required to pay out 90 percent of their earnings as a dividend. REITs are a special case, and the dividend payout ratios do not apply.

Using dividends to put a price tag on a company

You can tell a great deal about a company by its dividend policy, or track record of either paying a dividend or not. When a company doesn’t pay a dividend, for instance, it’s telling shareholders it still has plenty of profitable ventures to plow its extra cash into.

But using fundamental analysis, you can get even more information from a company’s dividend. Using a technique called the constant dividend model, you can get a rough idea of what a company’s stock price should be based on the dividends the company pays. The formula looks like this:

Value of a stock = (Next year’s dividend) ÷ (Required return – Dividend growth rate)

You’ll need to make a number of assumptions to use the constant-dividend model. First you need to approximate what you think the company’s dividend will be next year. Secondly, you need to estimate what return investors are demanding in exchange for providing their cash to the company. This is a complicated analysis I’ll discuss in more detail in Chapter 11. Lastly, you must guess at what rate the company will increase its dividends in the future.

At this point, let’s just assume Ford plans to pay an annual dividend next year of 60 cents a share, investors will demand a return on their money of 11 percent, and dividends will grow by 8 percent a year. You can measure the value of the Ford’s stock this way:

Value of stock ($20) = 0.60 ÷ (0.11 – 0.08)

Pretty cool, eh? You just put a price tag on Ford just by using the company’s dividend and a few assumptions. If all your estimates come true, Ford’s stock price on August 18, 2022, of $16.15 would appear to be slightly undervalued compared with the $20 you calculated shares to be worth.

If you haven’t noticed, the assumptions you make can dramatically alter the results of the constant-dividend model. For instance, if you assume dividends will grow by 3 percent a year, instead of 8 percent, the value of the stock falls to $7.50, which would make Ford’s current price appear grossly overvalued.

The constant-dividend model only works on companies that pay a dividend. Many smaller or faster growing companies do not pay dividends. With those types of companies, you’ll need to use the discounted cash-flow model, as explored in Chapter 11.