Top Financial Ratios
Dividend investing is part art, part science. Financial ratios make up most of the science behind investing.
What exactly are financial ratios? For the purposes of this article, we define financial ratios as any number or calculation used by dividend investors to better understand an investment opportunity.
Financial ratios are found throughout a company’s financial statements, annual reports, investor presentations, and more. Some examples of common financial metrics include return on equity, payout ratios, and price-to-earnings multiples.
While there are literally hundreds (if not thousands) of different financial ratios, understanding a handful of the most important indicators can help investors make better informed decisions and sidestep avoidable mistakes.
[drizzle]In case you are wondering if it’s worth putting in the time to learn about financial ratios, Warren Buffett’s advice might be enough of an encouragement to get started:
“Accounting is the language of business, and you have to learn it like a language… To be successful at business, you have to understand the underlying financial values of the business.” –Warren Buffett
Let's take a close look at the financial ratios that are most helpful for evaluating different businesses.
Top 10 Financial Ratios for Dividend Investors
Top Financial Ratios 1. Dividend Payout Ratio
The dividend payout ratio is perhaps the most common financial ratio known by dividend investors. The dividend payout ratio measures how much of a company's earnings are paid out as a dividend.
To calculate a company's dividend payout ratio, simply divide the amount of dividends it paid over a certain time period by the amount of earnings it generated. For example, if Coca-Cola has a payout ratio of 60% over the last year, the company might have paid $6 per share in dividends while generating $10 per share in earnings ($6 / $10 = 60%).
Investors like to analyze the dividend payout ratio because it can inform how safe a company's dividend is and how much room it has for future growth.
A high payout ratio (e.g. above 70%) could mean that the dividend payment is riskier because it consumers the majority of a company's earnings. If business trends unexpectedly fall, there might not be enough profits to keep paying the dividend. Dividend growth can also be more difficult for companies with high dividend payout ratios unless earnings growth is strong.
Generally speaking, we prefer to invest in companies with payout ratios between 40-60%. However, we will invest in companies with higher payout ratios if their business trends are extremely stable (e.g. a regulated electric utility business) and they maintain strong financial health.
3M Company's dividend payout ratio below is an example of what we really like to see. Note how stable its payout ratio has been. Perhaps even more impressively, 3M has increased its dividend by nearly 10% per year over this period. The company's relatively flat payout ratio means that its dividend growth has been sustainably fueled by growth in its earnings.
Source: Simply Safe Dividends
Top Financial Ratios 2. Free Cash Flow
Without free cash flow, a company is unlikely to survive over the long run. That's how important this financial metric is and a key reason why we analyze it to find safer dividend stocks.
Free cash flow is calculated using the company's statement of cash flows. A company's capital expenditures (i.e. money spent on property, plant, and equipment) is subtracted from its cash flow from operations (i.e. net income adjusted for non-cash charges such as depreciation) to arrive at free cash flow.
If a company does not generate free cash flow, it does not have funds to return to shareholders via dividends and share repurchases, nor does it have sustainable cash flow to use for acquisitions or debt repayments.
Companies that fail to generate free cash flow typically have capital-intensive businesses with few competitive advantages. We prefer to invest in companies that consistently generate free cash flow in virtually every environment.
Paychex (PAYX) is one such business. The company provides a variety of payroll processing and outsourcing services to small and medium-sized businesses. Its operations require little capital and enjoy high recurring revenue, resulting in extremely consistent free cash flow generation. That's one reason why we own the company in our Conservative Retirees dividend portfolio.
Source: Simply Safe Dividends
On the other end of the spectrum, United States Steel Corp (X) has been an unpredictable free cash flow generator. The company must invest heavily in its capital-intensive steel mills and has little control over the prices it can charge for its products.
Source: Simply Safe Dividends
Looking at free cash flow generation alone, Paychex appears to be the more reliable dividend payer of the two companies.
Top Financial Ratios 3. Return on Invested Capital
Suppose you had $100 to invest. One company can turn your $100 into $105, but another company can produce $110 with your money. All other things equal, we would pick the second company because it can grow our money faster.
To keep things simple, that is what return on invested capital is all about. Businesses take in funds (debt and/or equity) and invest to generate a return for shareholders. Companies that earn higher returns can compound our capital faster and are generally more desirable. Companies that earn returns below what investors demand should, in theory, eventually go out of existence.
For these reasons, one of Warren Buffett's favorite financial ratios is return on equity, which divides a company's net income by its shareholders' equity. For example, if shareholders purchased $100 of stock to fund a company and it generated $10 of profit, the company's return on equity would be 10% ($10 of net income divided by $100 of equity). Buffett likes companies that earn a high return on equity because they compound earnings faster and usually have some sort of competitive advantage.
Return on invested capital is similar to return on equity, but it measures a company's return on equity and debt. This is a key adjustment because it helps adjust for differences in capital structures between firms so we can better compare them.
For example, suppose there were two companies that each had $100 worth of assets. Company ABC financed its assets all with equity ($100). Company XYZ financed its assets with $20 of equity and $80 of debt. Both companies generated $10 per share in earnings last year.
If we were simply looking at return on equity, Company ABC would have a return of 10% ($10 of earnings divided by $100 of equity). However, Company XYZ would have a return on equity of 50% ($10 of earnings divided by $20 of equity). At first glance, Company XYZ would seem like the superior business despite their identical level of assets and earnings.
Using return on invested capital instead, we would find that both companies generated a 10% return ($10 of earnings divided by $100 of total capital).
When we analyze a company's return on invested capital, we look at the level (e.g. 10%) and consistency of its