How I Analyze And Value Stocks

Get your calculator out!

Special note: This is going to be a very long article, but I didn’t want to break it into two pieces. I wanted to put something very special together here for you readers, but it may take some time both to read it all and absorb it. I really hope you enjoy.

I’ve been investing in dividend growth stocks for four straight years now – starting in early 2010 with $5,000 in my checking account and dreams of financial independence.

I now sit here in a plush seat of validity as I watch my six-figure portfolio filled with equity in 43 high quality businesses that have lengthy track records of raising dividend payouts continue to spit out more and more income with which I use to further build my compounding snowball with the power of reinvestment.

So obviously I’m a huge fan of the dividend growth stock investment strategy. In fact, if there were a fan club for dividend growth investing I’d probably be Chairman of the Board.

However, just because I’m a big proponent of purchasing equity in high quality companies that pay out rising dividends doesn’t mean I’m interested in slivers of these businesses at any price. Valuation is paramount, and as such to be a successful investor you’ll want to make sure you’re able to determine the fair value of stocks and purchase at or below whatever you determine fair value to be.

And today, I’m going to discuss how I analyze and value stocks. I don’t have a proprietary system or anything like that, but I do tend to follow the same steps, or guidelines, every single time I look at a company as a potential investment. Valuing stocks is part art and part science. I’ll first talk about the science side that uses hard numbers, and then follow up with the art side which is more nuanced.

I split my analysis into two separate phases. 
  
Part I – Quantitative Analysis

First, I look at the quantitative aspects of a company. These are the fundamentals; things that can be quantified. So, I’m looking at numbers, percentages and rates.

When performing quantitative analysis I’m looking at a lot of hard data. I’m looking at a company’s balance sheet, its income statement as well as cash flow statement. I’m typically using the last 10 years of data when investigating these numbers, because I feel 10 years allows business cycles to smooth out over time.

Growth Rates

It’s during this phase that I calculate the compound annual growth rate of important metrics like revenue, earnings per share and dividends per share. Although I don’t have specific growth rates in mind, I typically want to see at least mid-single digit growth in these numbers over the course of a decade or so. However, it’s important to compare a company’s growth rate against other companies in its competitive space. For instance, comparing how a medical device company grows revenue and EPS against a tobacco company wouldn’t make any sense. So once I determine how much a company is able to grow its top line and bottom line over a 10-year time period I try to compare that against competitors to see how it stacks up.

Payout Ratio

I then look at the dividend payout ratio against both earnings and free cash flow, and compare it against the historical payout ratio. I usually invest in companies that have ample coverage of the dividend through both earnings and FCF. A quick check of the dividends per share against earnings per share can give you an idea of whether or not future dividend growth can continue, and looking at a simple payout ratio like this I try to make sure the number is 80% or lower.

Now I prefer a much lower number, and I usually try to invest in companies with payout ratios of 60% or lower. Typically speaking, the higher the yield the higher the payout ratio will be, and vice versa for lower yielding stocks. As such, I’m willing to work with a higher payout ratio that you’ll sometimes find with higher yielding tobacco, telecommunications and utility stocks. However, keep in mind that the higher the payout ratio the less likely you’ll see big dividend raises in the future as it limits how much the company can raise its dividend over time. That’s why higher yielding stocks usually have lower dividend growth rates. I also want to make sure that free cash flow can cover the dividend amply when looking at the company over a 10-year time frame. Dividends are paid in cash, and so you want to make sure the company has the cash flow to cover its payout.

Debt

I also look at debt during the quantitative analysis phase. A large amount of debt can limit a company, much the same as it can limit you or I. If a company is busy spending cash on debt obligations that means it has less cash to send my way as a shareholder. As such, I try to invest in companies that have low debt obligations. I first look at the debt/equity ratio, meaning I’m looking at how much long-term debt a company carries when measured against total shareholder equity in the company. I personally view any ratio of 1:1 as acceptable, and a number lower than that is attractive. However, it’s important again to compare the company you’re analyzing against the competition. You’ll typically see manufacturing companies, utilities and telecoms carry higher amounts of debt against equity because of the need to finance certain large-scale projects and they typically have an asset-heavy infrastructure. On the flip side, you’ll usually see low debt/equity ratios with many consumer discretionary and staple companies because they don’t have as much infrastructure. For instance, a company manufacturing jet engines will need more infrastructure than a company making cookies.

However, I don’t want to invest in a company that is only financing its growth through debt. While leveraging can lead to outsized returns when used right, over-leveraging can be dangerous. Obviously, if a company can generate shareholder returns greater than the interest rate they’re paying on debt then this can be a great tool to reward owners in the company. However, it’s important as well to not load up the balance sheet too heavily as this debt will eventually have to be paid and this can limit the use of cash in the future.

Another ratio I like to look at when analyzing a balance sheet is the interest coverage ratio. This is calculated by dividing a company’s earnings before interest and taxes (EBIT) by the interest expenses. You’ll want to use the same time period for both numbers to make it accurate. Any number lower than one indicates a company does not generate enough revenue to cover interest expenses. So the higher the number, the better. I typically want to see a number above five, but this isn’t set in stone.

Return On Equity

Another important metric is return on equity. ROE can be calculated by dividing net income by shareholder’s equity. ROE will show us how much profit a company generates with shareholder equity. This is a more general metric to determine profitability of a company. While the higher the better, I don’t aim for specific numbers here. However, I do want to make sure the company is seeing stable returns on equity, as a declining ROE shows a negative trend in profitability. Again, I try to compare apples-to-apples by looking at the competition within the same industry.

Yield

This is an easy metric to find and compare against not only other companies within the same industry, but all other investments available to an investor. As someone who is trying with everything I’ve got to acheive financial independence by way of living off the dividend income my investments provide, the higher the entry yield on an investment the more income I can receive, and therefore the quicker I can acheive early retirement. However, higher yield will sometimes have trade-offs like lower growth or perhaps more risk. After four years of active investing in equities, I’ve found it unproductive and risky to chase yield. I usually find the investment opportunities with the greatest potential total return are the equities that yield 3% to 4% with growth rates of the dividend in the 7% to 10% range. Many dividend growth investors call this the “sweet spot”, and for good reason. Chasing a stock yielding 8% won’t get you very far if the dividend can’t grow, or is cut, and the stock price languishes or falls. You’ll find that the bulk of my portfolio is invested in companies that fall squarely in the aforementioned sweet spot – companies like Johnson & Johnson (JNJ), PepsiCo, Inc. (PEP) and Philip Morris International (PM).

Valuation

Once I determine a company is worthy of investment because of solid fundamentals like low debt, high ROE, solid growth rates and a low payout ratio I then have to actually value the stock. I’m typically first going to look at the price/earnings ratio here (P/E), because this is a fairly standardized metric that can be compared against not only other companies within an industry, but companies across all other industries as well as the broader stock market as a whole. I try to limit my purchases to those stocks that have P/E ratios less than 20, generally speaking. In my opinion, one of the most important things you can do when looking at the P/E ratio is comparing the current ratio against a company’s historical P/E ratio to see if today’s prices are within reason. I usually compare today’s P/E ratio to the 5-year average so that the numbers can be smoothed out and compared. While a P/E ratio of 15 may seem attractive when compared to the 100+-year Shiller P/E average, if a company is typically valued by the market with a P/E ratio of 11 you might not be getting a cheap stock.

I also tend to look at the price/book, price/sales and price/cash flow metrics here, and while I’m not looking for specific numbers I use these for comparative purposes against industry standards.

This is also where I value a company using a typical Dividend Discount Model analysis. There’s a number of ways you can quantitatively boil a company’s valuation down to a reasonable range, and a DDM, as well as a Discounted Cash Flow analysis, is fairly popular and certainly viable. A DDM tries to to predict all future dividend payouts by a company and discount them back to present value. Since any company is only worth all the future cash it can generate, looking at the shareholder return via dividends is certainly a reasonable way to value a company. The most simplistic representation of the DDM is to divide dividends per share by what you get after subtracting the dividend growth rate from the discount rate. However, I use the spreadsheet that Matt Alden from Dividend Monk developed because, frankly, it’s quicker, easier and just plain looks good.

When using a DDM I use a 10% discount rate, because that’s the return I’m after. Your discount rate is essentially the annual return rate you’re trying to achieve. A 10% rate of return on equity across an entire portfolio is a solid risk-adjusted return, in my opinion, and within reason of what the stock market has returned historically. Furthermore, it’s of my opinion that anyone seeking financial independence does not need superhuman returns in the stock market to acheive FI, or early retirement.

After accounting for my discount rate I then have to factor in the growth rate of the current dividend. This is obviously a little art and a little science, since nobody can predict the future. What I do to reasonably estimate the long-term dividend growth rate is look at the historical EPS growth and dividend growth rate the company has been able to achieve over the last 10 years and project that out over the long haul with a margin of safety. By that, I mean if a company has been able to grow earnings by 8% and the dividend by 9% over a fairly substantial period of time I might predict the growth rate at 7%, which is less than both numbers. Furthermore, a company growing the dividend faster than earnings can only do so by expanding the payout ratio so you’ll want to look at both earnings and dividend growth to be able to reasonably estimate the dividend growth looking out over the long haul.

Part II – Qualitative Analysis

This is the art side of valuating a company. The qualitative analysis phase is where I look at qualitative aspects of a company – meaning they can’t be easily quantified, but still have substantial merit as well as a significant effect on the valuation. This phase of analysis is where I ask myself what the company in question does. How do they make money? Is it reasonable to conclude that they’ll be able to keep making money in the future using the current business model? Do people like their products? Why or why not? Are the products or services the company produces or provides worth a premium they may or may not charge? Do they have a good reputation? What’s the competitive landscape like? Is there a favorable or unfavorable regulatory environment? Is the company diversified, or do they overly rely on one product or service? Are they able to transform themselves when necessary?

Economic Moat 

A term coined by Warren Buffett, it’s important to look at every company as a castle. And around this figurative castle is a moat. And it’s this moat that protects the business against the hoards of marauding competition from destroying the castle. The bigger the moat, the more likely it is that a company will be viable and profitable for many years to come.

Competitive Advantages

Typically speaking, when trying to determine the size of an economic moat we’re looking at competitive advantages. When I’m analyzing a company for competitive advantages I pour over the annual report which gives management an opportunity to explain to me, as a potential shareholder, exactly what, if any, competitive advantages the company possesses.

When I think of competitive advantages I think of anything that gives a company a leg up on the competition. And competition is not only the companies that are actually out there doing business, but also companies that could potentially be conceived at any time.

Economies Of Scale

So when pouring over annual reports I look for advantages like economies of scale, which provides a company increased profitability with increased production by way of lower per-unit fixed costs. For instance, it would be incredibly difficult for a new beverage company to compete with The Coca-Cola Company (KO) because Coca-Cola is able to produce its beverages at very low costs because it’s bottling huge amounts of liquid at a time. This allows Coke to buy raw materials at very cheap rates because it’s buying everything in massive bulk. A new beverage company, on the other hand, will not have this type of negotiating power and, therefore, will see its input costs rise and the cost to manufacture every bottle rise.

Being a low-cost producer is another advantage of having significant economies of scale. Wal-Mart Stores, Inc. (WMT), for example, is well-known for their ability to stifle competition because they’re able to supply the market with cheaper goods than the retailer next door. They’re able to negotiate with the product manufacturers because of the ubiquitous nature of their stores. With a massive supply chain and storefronts seemingly everywhere, Wal-Mart can supply consumers with products at lower costs. As such, this is a difficult economic moat to conquer.

Furthermore, economies of scale also allow a company to negotiate other aspects of the business. For instance, they may be able to get bigger loans with smaller interest rates, which would allow them to potentially acheive higher returns for the shareholders than what a smaller company could.

Distribution

Another big advantage is distribution networks. Take Coca-Cola again. Their products are available in over 200 countries. This gives them not only an advantage against potential upstarts, but against all other businesses they compete against right now in almost every country in the world. Since their product is ubiquitous, it’s easy to know exactly what you’re going to get when you open a bottle of Coca-Cola or anything else they manufacture and sell. Furthermore, this type of geographical diversification allows them to participate in markets all over the world which allows the company to smooth out growth over time simply because some markets will be growing faster than others.

Brand Name

Keeping with our Coca-Cola example, can you think of a company with a more well-known brand name? This brand power is a huge advantage over rivals, because it allows the company to maintain a certain pricing power – meaning they can charge a market premium for products which ensures better margins. Remember those old ads that showed you could buy Coke for a nickel? Well, like any high quality product Coke costs a lot more these days. And you can be assured that it will cost more 10, 20 and 30 years from now. High quality, brand name products have inflation protection built right in because once people get used to using a product they’re likely to keep using it. Brand loyalty allows companies like Coke to pass along input cost increases to customers, along with any price increases that otherwise warranted by business demands. And I think this is realistic. As a consumer myself, I don’t expect the price on things to stay the same forever. We all know prices go up. So it’s no surprise when the price of Coca-Cola is more expensive today than it was a decade ago, and as such people are inclined to keep buying it. Especially when the price of everything else goes up with inflation.

Barriers To Entry

All of the previous competitive advantages are barriers to entry in themselves, but sometimes you actually have significant industry-specific barriers to entry that makes it even more difficult for the competition to overcome a moat. Railroads are a great example of this. I’m invested in Norfolk Southern Corp. (NSC) not because it has a brand name product, but because it’s just about impossible for another railroad to start up and compete. The railroad track that’s already laid out in the United States is likely all the track you’ll ever see. And so the barriers to entry in this business are extremely high. Even if a company could manage to build new track, which is nigh impossible, you’d have huge start-up costs that would require massive capital and make any venture extremely unprofitable right from the get go. As such, the existing railroad companies are a great investment on fixed assets that are very valuable.

High Switching Costs

This is another competitive advantage that a high quality company can employ, and when used correctly can be extremely effective without even really trying. This particular advantage is one reason I’ve invested in International Business Machines Corp. (IBM). Once a particular business decides to integrate IBM solutions within their IT infrastructure, it can be quite difficult to switch to another provider. This gives IBM a built-in advantage which is quite easy to maintain as long as they continue to provide the services and solutions they promised in the first place. As such, recurring revenue sources can be easily built and maintained.

Margin of Safety

One final piece of the puzzle is trying to build a margin of safety into the valuation of a stock. While a company can have great fundamentals and solid competitive advantages, as I said earlier you don’t want to overpay for a stock because it can lead to poor returns over the long haul. And although I would argue it’s hard to overpay for really high quality companies, why overpay if you can get a stock for an attractive price?

I try to build a margin of safety into my valuation in two ways. First, as I discussed above I try to use a conservative growth rate when valuing a stock using the DDM. Second, I then try to buy a stock for a price less than what my DDM analysis determines is fair value.

For instance, I published my recent purchase of shares in Target Corporation (TGT). Now I used a Dividend Discount Model to reasonably value shares using a 10% discount rate and a 8% long-term dividend growth rate. I used this 8% number even though EPS has a compound annual growth rate of almost 9% over the last 10 years and the dividend has grown at a CAGR of over 18% during this same time period. The input led me to determine that it’s reasonable to assume that TGT shares are worth upwards of $93. But I didn’t pay that much; I bought shares for only $62.50.

This is building a margin of safety in action. You see, you want to minimize risk as much as possible when investing in stocks. And one great way to minimize risk is to buy as far below a reasonable fair value range as possible. This way, even if you’re input is flawed or the company faces unexpected trouble which causes growth rates to skew downward you still stand a chance of making money, or at the very least not losing very much. You can’t determine the future, and valuing stocks is not an exact science. You’re using past numbers to gauge future growth, which can be quite difficult and sometimes inaccurate. Therefore, you want to be quite conservative when valuing, and then buying, stocks. A margin of safety is conservatism in action.

Part III – Tools To Use

I’m going to conclude this article with tools I personally use to analyze and value stocks.

One tool I use quite often is Morningstar – a free website that includes the past 5 years of cash flow statements, balance sheet information and income statements for free for most publicly traded companies. Morningstar also gives you the current P/E ratio against the 5-year average by clicking the Valuation tab at the top of the page. Furthermore, I like to compare the fair value I come up with for stocks against what their professional analysts determine. I use their numbers to concentrate my valuation and this gives me an idea of where I stand.

Another tool I use is S&P Capital IQ analysis reports, which are free through my brokerage. S&P Capital IQ provides 10 years of financial data for most companies, a fair value calculation from one of their professional industry-specific analysts (typically using a DCF model) and a short synopsis on their view of the qualitative aspects of the company. I compare this against what Morningstar and I come up with for fair value and this further allows me to concentrate my value and determine if my numbers are way off. If I’m way off from what professional analysts value a company’s stock at I try to determine why. Maybe I was a bit more conservative or aggressive in my assumptions, but I tend to ultimately stick with what I conclude after a lengthy analysis session.

Finally, what I most like to use is a company’s own investor relations site. This is a fantastic tool to analyze a company, especially the qualitative aspects as the annual report gives management a chance to really show where the company is going and how they’re going to get there. You can usually find quarterly reports and conference calls on these sites, and this allows you to compare the financial statements you may find on some of the above third party sites to double check the results. I personally love reading annual reports and comparing them against older annual reports to see if management is living up to expectations. Although annual reports are rightly biased, I still think it’s a great way to read about what a company is doing to position themselves for future profitability.

Conclusion

Tying it all together, I basically try to determine if the fundamentals look great. I want to invest in companies with low leverage levels, and if the debt is a little higher than I might like I want to at least make sure the company is getting satisfactory returns for shareholders on that debt. I look for low payout ratios on both earnings and FCF, which should ensure solid dividend growth in the future. I want a company that is able to grow, because without top line and bottom line growth the company will eventually lose the capability to grow the dividend payout. And when looking at yield, I usually shoot for companies that have a solid entry yield, but also grow the dividend at levels far above inflation which ensures me that my purchasing power will only increase over time.

Once I determine that the fundamentals are sound, the yield is right and the growth is there I take a look at the competitive advantages a company has. Do they have economies of scale? Are they a low-cost producer? Do end-users like their products and/or services? What are the barriers to entry which will limit competition?

If I conclude that a company is both quantitatively and qualitatively attractive I then value shares using a DDM analysis and try to build in a margin of safety both with the growth rate I use and the ultimate price I attempt to pay for the stock.

Full Disclosure: Long PEP, JNJ, PM, KO, WMT, NSC, TGT

I hope you enjoyed this post! This is a piece I’ve been thinking about putting together for some time now, but for one reason or another never got around to it. What do you think? Do you analyze and value dividend stocks in a similar manner? 

Thanks for reading.

Photo Credit: adamr/FreeDigitalPhotos.net

Edit: Corrected grammar and expanded ‘Brand Name’ subsection.

Comments

  1. says

    Great post and I always love getting to find out what others use. I’ve found some other great informations sources that way and I need to check with my brokerage to see what all fun research tools they have. Our approaches to valuing stocks are very similar. Thanks for the insight.

    • says

      Pursuit,

      I think you’re right. I’ve read your analyses before and it looks very similar to what I’m talking about here. It’s an arduous process, but well worth the results in the end. I often talk about all of this stuff in my ‘Recent Buy’ articles, but I thought I’d put it all down in one post.

      Best regards!

  2. says

    Very nice post, most of these are new to me, I am wondering how I managed to build my portfolio, again all the credit goes to fellow blogger website where I learn new things. I am planning to also indulge in some financial book, if you know any let me know.
    Thanks once again for this wonderful post, it broadened my horizon and resources.

    Dividend Mom

  3. says

    Nice article. I follow a similar approach, although I weight quite a bit more to the qualatative rather than the numbers. I’m most focussed on the moat, and I specifically look towards consistent gross margins and revenue growth as evidence of a moat that’s intact.
    I tend to skew more to top line revenue growth as my ultimate determinant for investment, which is one of the reasons I tend to stay away from stocks like IBM, even though they have a strong market niche.
    Be a little careful on putting too much emphasis on valuations. I’ve done company valuations professionally for a living, they can be very easy to manipulate, and the reality is nobody really has a good idea about future projections. I’ve found the past can be a very good predictor of the future, in many instances :)
    Best!

    • says

      Integrator,

      I agree with you. I’m actually going to write a follow-up post that talks about why I value qualitative aspects of a company more than hard numbers, especially when attempting to forecast future growth rates and returns. Obviously, when looking at certain fundamentals we’re looking at the past, while focusing on qualitative analysis allows you to focus on the future.

      Best wishes!

  4. says

    Great job, Jason! Thank you very much! You hit a home run with this one. I’m gonna bookmark this post so I can use this information next time I research a stock. This post is an excellent resource for both new and experienced investors alike!

    Dave

    • says

      Dave,

      Thanks a ton! I really appreciate it. I wasn’t sure how such a long post would be received, but it seems like most readers that have taken the time to stop by and comment really enjoyed it.

      Cheers!

    • says

      Chris,

      Glad you enjoyed it! I’m not sure how many pageviews it will get because it’s longer than what I usually post, but this was an article I’ve been meaning to put together for quite a while.

      This post is the culmination of what I’ve learned, and it shows how my analysis process has gotten longer and more in-depth. I guess I just enjoy researching companies. :)

      Best regards.

  5. says

    I just started doing DRIP investing. I am impressed with your portfolio and how in such a short time you have a nice little nest egg.
    What kind of spreadsheet do you use or tracking for tax purposes when it comes to cost basis?

  6. Spoonman says

    What a Tour de Force! Thank you for putting together such a nice post. I think anyone can use this as a guide to evaluate companies, new and experieced investors alike. I especially like your list of qualitative factors because they really give you an intuitive sense of what a company is all about.

    One “metric” that I like to use is the number of times I see a company’s trucks or factories in a given period of time. I get a warm fuzzy feeling every time I see Sysco truck delivering food, or a Waste Management truck picking up trash. A few months back APD became a buy, but what compeled me to become a shareholder was the fact that their trucks and factories are in plain sight here and there.

    You should file this post under your list of DM Classics!

    • says

      Spoonman,

      I remember after I invested in Sysco a few years ago I started noticing their food service trucks everywhere. It’s kind of like when you buy a certain car you start to notice other people driving the same model. Funny how that works!

      Glad you enjoyed the piece. I spent some serious time on Sunday putting it together, but it was well worth the effort.

      Best wishes!

  7. says

    Jason,
    Very thorough analysis. One of my favorites is MO, the payout of 80% is high but they always raise dividends. High equity, moat and ability to raise prices. With the stigma of tobacco this stock has resulted in great returns for investors. Long MO

    • says

      Charles,

      MO has been a fantastic investment over the last few decades. In fact, the old Philip Morris stock was the best performing stock of the last 50 years last time I checked. It’s one of those rare companies that can maintain a high payout ratio, high yield, high dividend growth rate, large debt load, etc. The stigma you mention has allowed MO to stay relatively cheap for years, which allowed investors to continue to invest/reinvest in a cheap, but high quality stock. Worked out very well, however I do find myself concerned with when the company will no longer be able to counteract declining volumes with raising prices. I think a tipping point will occur at some point; I just hope I can see it coming.

      Best regards.

  8. says

    Wow Jason, that was a comprehensive post. Other than the models we use, we analyze our investments very similarly. Of course I figured we did, because we have many of the same dividend growth investments. I anticipate this will be one of your most popular (in terms of page views). I know it will make my weekly recap. Good work my friend. Have a great week.
    -Bryan

    • says

      Bryan,

      Thanks! I hope it offered some insight for a few investors out there.

      I certainly hope it ends up being a popular post if only because it can reach a broader audience. Time will tell. :)

      Best wishes!

    • says

      D-S,

      I was working on this post for a few hours yesterday. It took a lot longer to write than most of my articles because of the length and content, but also because I didn’t even have a rough draft. I just had the idea in my head and started writing. That’s generally how most of my posts are conceived.

      Glad you liked it. :)

      Take care!

  9. Anonymous says

    Great post!

    My only question, given your fifty hour work week, is how you do all this analysis of stocks while also writing your terrific blog?

    Whatever the secret, please keep up the great work!

    • says

      Anonymous,

      I wish I had a secret. To be honest, I’m constantly busy these days. I’m greatly looking forward to the day when I have more downtime. I’m not one of those people that needs to stay busy or active to feel “important”, or whatever. I quite enjoy being idle sometimes.

      Although I will say that I do most of my stock analysis on weekends. My week is just to hectic with work, hitting the gym, household stuff, etc. My girlfriend would probably tell you that I need to cut some of this stuff out, but I’m hoping that one day I’ll be able to just write and research stocks because that’s where my heart lies. :)

      Best wishes.

  10. says

    What an awesome post! I love detailed posts such as this one that goes into the basics. Spending time research stocks before you buy can pay off big time – just as Warren Buffett!

    • says

      moneycone,

      Due diligence is extremely important, or otherwise how do you really know what you’re investing in? Even major companies have surprises here and there, and as an investor it’s your job to know as much as you possibly can. Now, I’m not going to kid myself and say that research allows me to understand a company inside and out, and banks can be especially confusing. However, I feel like after taking a look at a company as laid out above I have a good idea of what I’m investing in.

      Take care!

  11. says

    DM,

    That post was amazing. I was wondering what influenced your decision to buy DLR. I ended buying shares right after you did and I am really glad that I did. It probably won’t be the next Coca Cola, but I like the margin of safety. I almost bought shares of TIS after your article, but unfortunately I don’t have enough cornerstone companies in my portfolio yet. Maybe I’ll buy some later this year. I have been reading The Intelligent Investor and I see a lot of similarities in your purchase criteria. Keep up the fantastic work.

    DP

    • says

      DP,

      DLR has turned out well so far, but we’ll see over the long haul. There are benefits and drawbacks to every business, but if your margin of safety is large enough the benefits will likely far outweigh any potential drawbacks. It gets to a point where the odds are so heavily tilted in your favor that you can’t not invest.

      TIS is an interesting play. I’m tempted on that one, and it’s one I’ll continue to watch. The upside is significant.

      Best wishes.

  12. says

    DM

    That’s funny you have that calculator graphic for this. I just had to buy one of those fancy graphing calculators for a Statistics class. TI 84 plus C Silver edition, hopefully its good for all my future classes and maybe can plug in some type of dividend or formulas for analysis.

  13. says

    Fantastic stuff, DM, and to an index fund investor like me it is incredibly interesting to learn about different ways to reach FI. I never knew how much could go into the analysis of a company, but it seems to be serving you well.

    Always happy to learn more and you’ve given us some great content here.

    • says

      DB40,

      An index investor like yourself doesn’t really need to go through the exercises laid out above, but I think it’s still good to know what to look for in case you ever find yourself in the position.

      Glad you enjoyed the post! :)

      Best wishes.

    • says

      Anonymous,

      Thanks! I really appreciate feedback like that. I wasn’t sure if readers would enjoy such a lengthy post, but I felt strongly about not breaking it up.

      Glad you liked it.

      Best regards.

    • says

      A Dahn,

      This is an article I’ve been wanting to write for a long time, and I just happened to have a nice Sunday morning to sit down and type it out before the football games started. I’m very happy that you enjoyed it!

      Take care.

  14. says

    Good stuff – thanks for taking the time to write this up and share it! Any dividend investor really needs to take the time to go through a similar process when considering potential investments. This will definitely be a bookmark and share post!

    • says

      Matt,

      Glad you enjoyed it. I agree that every investor needs to go through some type of process to screen out potentially negative investments. It’s in one’s best interest to do so.

      Best wishes.

  15. says

    Jason,

    I know this is kind of off topic, but what is your take on PM’s book value going so deeply negative over the last few years? Is this something you would be concerned about? why or why not?

    • says

      Spencer Stojic,

      I’m not overly concerned about that, because, as investors, we’re not investing in PM because of its infrastructure or asset base. It’s a cash cow that sends most of the cash it generates shareholder’s way. However, that being said I am a bit worried about the debt levels continuing to creep upwards. I understand they’re able to borrow at low rates and buy back stock, but at the same time I don’t want to see that continue ad infinitum.

      Cheers!

  16. says

    Wow! That is an epic post and a half. I don’t go that deep in my research. I look into P/E (as compared to industry), Operating Margin (as compared to industry), B/V and yield. Seems like you went deeper into non-qual which is fantastic!

    • says

      Evan,

      Not everyone will do as much analysis as me, and some will do more. In the end, you only have to use a system that works for you and allows you to acheive your goals.

      Thanks for stopping by!

      Best wishes.

  17. Anonymous says

    Hi Jason,

    Thanks for sharing this valuable information. It is nice to have someone else’s DD to compare your own to. I know your not a professional but I would trust your stock recommendation over a “professional’ any day. You are very thorough in your analysis. Your blog is very inspiring and I am aways looking forward to your next post.

    Frank

    • says

      Frank,

      Thanks for the very kind words there! I really appreciate that. I take pride in my analysis and my writing, so when people appreciate it I’m very grateful. Thank you!

      Best wishes.

  18. says

    Great article! I have a similar set of articles on Value Investing which you might find interesting:
    http://www.genwisewealth.com/value-investing-tools-and-methods-to-find-value-part-3-of-series/

    A few questions: Why the emphasis on current income and yield now? Any dividends a company pays out is cash not used to re-invest in the business and grow. What are your thoughts on compounding capital by investing in companies that retain earnings or buy back stock rather than pay it out? These growth and/or value oriented firms tend to grow book value faster (think Berkshire Hathaway…Buffett will never pay a dividend!). While you have current income from an outside source (e.g. employment), I’d suggest targeting capital creation and return before dividend yield. You’d certainly save on dividend income taxes! This could potentially grow your portfolio faster.

    In retirement, your large portfolio can then be allocated to more of these blue-chip dividend growers.

    What do you think?

    • says

      Wes,

      I’ve been pretty open about my reasoning in regards to being a dividend growth investor and enjoying dividend income. But retained earnings aren’t always all they’re cracked up to be. If Procter & Gamble stopped paying a dividend tomorrow and used those retained earnings to grow the business, could they allocate that capital better than shareholders? Would they get as much value out of that capital? Certainly, the ROE would change dramatically because you’re changing equity, but would that help or hurt? If PG can continue to grow at 7% or so rates while handing out half of profits, is that not a fantastic investment already?

      I need dividend income to pay my bills with. I would never want to be in the position of having to sell of part of my portfolio in early retirement, relying solely on what Mr. Market might value my equity stakes at. No, thanks.

      It should also be noted that my timeline to financial independence/early retirement is shorter than most. I’m trying to retire by 40 years old, and so it’s imperative for me to start building my income stream now, rather than switch gears last minute and then start relying on passive income. Switching strategies like that would be akin to me jumping from one airplane to another mid-flight, when I could have just been on plane #2 all along.

      Cheers!

    • says

      Dodie,

      It’s tough to find value right now, but I think some of my recent purchases are attractively priced. GE, PM and TGT are three ideas for example. I also find O, KMI, BP, and ARCP as strong opportunities right now. And almost all of them have higher yield as well. :)

      Best of luck! And I’ll try to go over some more opportunities soon.

      Cheers.

  19. D Garner says

    Good stuff! Thanks DM. How do you track and keep your data and investigation organized ? That’s my challenge. Assuming not all investigation leads to purchase yet — as stock may not clear your “barrier to entry,” what tools (excel, paper, google portfolio, watch lists, etc) do you use to track & monitor your data and watch lists working forward? Thanks agin for your work.

    • says

      D Garner,

      Thanks! Glad you enjoyed the post.

      I use the watch list tool my broker (Scottrade) provides. I add a list of stocks to it, and it allows me to watch the price action. As far as tracking the fundamentals, I always reacquaint myself with this before I buy. It’s time consuming, but there’s no free lunch. Besides, I enjoy all of it. :)

      Cheers!

  20. Alfred says

    Dividend Mantra,

    Out of curiosoity, how much is your portfolio worth today after the initial investment of $5k? It would be very interesting to know.

  21. William Richard LeDuke (aka "Richard the Duke") says

    First I want to say that I enjoy reading about your methodical plan for dividend-funded financial independence. I have been on a similar trail after several years of long-shot bets that always went to zero. I do have a question that I have not seen answered. In my quest to find high yielding dividends I have run into several investments that carry whai I now refer to as “not worth the hastle” factor. In a short time I ran into foreign tax deductions (as close as Canada),and limited partnerships that proved to be a nightmare for my taxes since they did not even supply the 20+ page tax documents until days before my April 15 deadline. Some of these investments paid very large yield, but as I said, I now consider these investments as not worth the hastle. If you’ve discussed this before, please guide me in the right directions because I really do want to know if you have some additional “filters” that you apply.

    I didn’t mention specific names but would be willing to do so. Thanks for the good work. I look forward to your response.

    Richard the Duke

    • says

      Richard,

      I’ve never written a specific post on those types of investments, but I have referred to avoiding a number of investment types in comments. Specifically, I avoid MLPs because of the tax complication. And when I discussed my KMI purchases I make mention of that in regards to why I went after the general partner. Of course, the IDR and faster growth are a big part of that as well.

      I do have some small exposure to REITs. And I’ve found reclaiming foreign dividend tax withholding quite easy. But I do purposely avoid MLPs.

      Cheers!

      • Richard says

        I have a “good” problem. I just received approximately $100k into my IRA. With today’s market, would immediately put it to work?

        • says

          Richard,

          What a great problem to have!

          If I came across $100k tomorrow I wouldn’t invest it all in one shot. Partially because I don’t have enough good ideas and partially because I’d prefer to dollar cost average the money in over, say, six months to one year.

          Enjoy your fortuitous position!

          Best regards.

            • says

              Richard,

              Stocks?

              To be serious, I don’t keep a lot of idle cash around. Cash is going to lose value via inflation if you’re not investing it. However, if you like to keep a lot of cash around on the sidelines in case of a market pullback the best place to look would be a high-interest savings account. I’ve seen some as high as 1% or so, which isn’t bad.

              Best regards!

  22. Muhammad says

    Jason, thanks for the article!! i can tell that this is a GOLD MINE!!!! you see im studying for a chartered financial analyst charter (and im currently enrolled for the level 2 exam this june) and altough i started like everyone else that is from scratch, i now have come a long way you see i now am able to value and evaluate indivdual companies BUT we have not been taught these strategies such as dividend growth investing as yet…..when i came across your blog i was really excited!!!cause this looks like a good plan to reach my mountain top!! you’ll be hearing from me from time to time from now onwards as i would love to come here and take advantage from your expereince and expertise!!

    thanks a lot once again! and keep up the good work!.

  23. Muhammad says

    thanks a lot for the support Jason! this means a lot to me. one quick question……if you were analysing a new company in a new industry with which you were not well acquainted…….how long does it take you to analyse the qualitative side of things? for instance whether the company has a wide economic moat or not? do u go through all the 10K and other related documents before making a decision? you see ive been too busy for the last couple of years to get the hang of the valuation side of it all…..now ive just recently started actually analysing new companies on my own and was interested in how you would approach a new company you were researching? would you go to the financial statement analysis (ratio analysis) first ? and then look for clues for the qualitative factors such as economic moats and more?

    • says

      Muhammad,

      It’s tough for me to answer that question. I don’t really time myself as to how long I might spend on a company. Furthermore, every company is different. The amount of time I spent looking at AMNF the first time around, for instance, far exceeded the amount of time I spent looking at Unilever for the very first time. Perhaps that’s wrong of me, perhaps it’s not. But I suppose you give some benefit of the doubt to a multinational company with a market cap well over $100 billion versus a tiny food company.

      That all being said, I imagine I spend at least two hours looking at a company for the very first time. That includes the last few annual company reports, recent quarterly results, recent investor presentations, analyst reports, etc.

      Economic moats are somewhat subjective. What one person feels about a company’s competitive advantages may differ from someone else. But I generally try to look for companies that have competitive advantages like pricing power, barriers to entry, cost or quality advantages, brand name products, etc. I also try to combine that with strong value, low risk, and high quality to varying degrees.

      I hope that helps!

      Best regards.

      • Muhammad says

        thanks again jason!! appreciate the quick response. :)

        a few more question!! i just valued a company yesterday thanks to your writing that actually made me over come my analysis paralysis and i finally over came my fears and went on to achieving success!

        but in valuing the company i came across certain problems!

        problem number 1: company’s free cash flow are highly volatile. although the free cash flows have been increasing over time (starting from negative 306 million (rupees) up to positive Rs. 772 mn in 4 years! i know its pretty crazy!). my question, keeping this siutation in mind can i value company on free cash flow? if yes then what growth rate do i use since growth rate of free cash flows is negative?

        problem number 2: company also pays a dividend which is also not consistently growing over time however if i want to force it i can see an upward trend. my problem is again in valuing the company. my question here is that can i use DDM when the company’s payout ratio (dps divided by free cash flow per share ) for 2010, 2011, 2012 and 2013 are -66%,-382%,534%,117%, respectively? average payout ratio over last 4 years is 64%. what should i do here? oh and company’s pay out ratio (dps divided by EPS) is pretty consistent. averaging around 41%.

        your response would be very helpful . :)

        • says

          Muhammad,

          Those are good questions.

          You can use what’s called the discounted cash flow model analysis if you’d prefer to value a company using cash flow metrics. However, I tend to use long-term numbers when looking to value a company. If one year was particularly bad over a 10-year period, then that’s probably due to one-time events and not indicative of their long-term cash-producing power. It sounds like you’re only looking at four years of data. I don’t personally find that relevant enough when you’re trying to value a company. The DCF (and DDM) models are trying to forecast very long-term numbers, and I just don’t think four years is a good proxy. If the company is producing negative free cash flow all the time, however, then you probably simply have a bad investment on your hands, in my opinion.

          As far as the payout ratio goes, that’s not really a number that’s used at all in a DDM analysis. You’re simply looking at the current dividend, the predicted long-term growth of that dividend, and then trying to discount that back to the present day to account for the time value of money. The payout ratio is a metric I obviously look at with every investment, but that’s really more for the sustainability of the payout. If I didn’t feel the dividend was sustainable, or perhaps would grow less quickly in the future due to a high payout ratio, then I would simply use more conservative numbers in modeling the value to compensate for that.

          Cheers!

          • Muhammad says

            jason, your right! i was using just 5 years worth of data and that doesnt give us the actual picture of things to come…..we need to go even further in the past to be able to predict the future even if it isnt going to be 100% accurate.

            oh and after having read your post i added more data to my model and ended up rejecting the company as a potential investment just because the free cash flows were negative in a lot of years……like they say that it was a recepie for disaster.

            btw the reason i was even looking at the investment was because the most recent figures (2013) had shot to the sky and some fundamentals have changed for the company which may indicate that the company may countiue to make positive free cash flow in the future but i think i will sit back and let the company prove itsself to me(something i picked off Warren Buffett). if the company really has potential in the future then i should get plenty more chances in the future.

            thanks for the response!

            P.S: i got another great investment today after having rejected the company i had reffered to earlier. like they say it pays to pay attention to the fundamentals of the underlying business!

            CHEERS!

      • Dave says

        Hi again DM,

        Are you ever concerned with taking at face value the key ratios on a company reported by morningstar or s&p capital iq? While researching into fundamental analysis it’s a little overwhelming to see how many subtle ways companies can report numbers differently. For example one might classify developing internal software systems as an asset on cash flow (increasing CFO) instead of an operational expense. Maybe inventories are tracked using FIFO instead of LIFO, and thus completely changing working capital & profit margins. How are you accounting for things like this when comparing a company against it’s competitors for example ? It seems very difficult to get to a point of comparing apples to apples

        • says

          Dave,

          I think it really comes down to whether or not you trust the numbers companies are putting together. I would assume that GAAP compliance and audits are enough to secure that trust, but that’s just me. If you don’t trust the numbers companies are putting together, then that makes it difficult, if not impossible, to invest. Of course, every once in a while you run into fraudulent behavior – Waste Management, Tyco, Enron, and most recently ARCP. But on the whole, I assume the numbers I’m looking at to be accurate. And I’ve done fairly well thus far with that trust.

          Best wishes!

          • Dave says

            Thanks, yeah I didn’t necessarily mean cases of fraud, but more so the various ways a company could choose to account for things all of which are GAAP (like my LIFO vs FIFO inventory example). Seems like one would have to normalize things when comparing companies, but maybe I’m getting hung up on non-issues in reality. I’m just going through a bunch of tutorials on financial statements at this point trying to get a handle on things.

            Some of the normalization adjustments I’m referring to are kind of outlined on this page below under the heading ‘Adjusting Cash Flow from Operations (CFO)’
            http://www.investopedia.com/university/financialstatements/financialstatements3.asp

            • says

              Dave,

              Right. Well I go about “normalizing” that by using a decade or so of financial results. This smooths out temporary fluctuations or adjustments, and also evens out accounting metrics so that each company’s results are looked at over a lengthy period of time. Whether you use LIFO or FIFO, for instance, isn’t going to matter much when you’re looking at how a company is performing over a decade.

              Navigating your way through financial statements is important, no doubt about it. But some of that (like LIFO vs FIFO over a long period of time) is missing the forest for the trees, in my opinion.

              I think there are genuine concerns in regards to financial statements, most notably with MLPs and how there is no standardized method of accounting for DCF. But I don’t think what you’re talking about is one of them. Of course, opinions will vary on that. Just my take.

              I hope that helps!

              Cheers.

  24. Abhi says

    Hi DM,
    I have a question. I have been following your blog recently and I am interested in DDM. I tried to find the intrinsic vaue for Walmart but somehow not able to get the correct value. So we have to subtract the dividend growth rate from the discount rate , right? What if the Dividend Growth rate is more than Discount rate.
    For e.g : For Walmart the CAGR Dividend Growth rate for last 13 years has been 30.3%, in that case my discount rate is less than CAGR DGR. What do i do in that case? Or do i not consider the 13 year CAGR and just consider the year to year Dividend Growth?
    Please clarify with an example.

    • says

      Abhi,

      You have to keep in mind that your dividend growth rate is a permanent growth rate, going basically out to infinity. I would think it’s probably inaccurate to assume that Wal-Mart can continue growing its dividend by that kind of rate forever. I generally use rates between 3% and 8% for my valuation models, depending on what kind of growth a company has posted over the last ten years and what I think will be realistic out over the long haul, factoring in organic growth, buybacks, and acquisitions. 8% is aggressive itself, and I don’t even go that high very often.

      If you think a company will grow at a 13% constant rate forever, which would be unlikely, you’ll have to use a higher discount rate. That’s because it’s not possible for a company to grow at 13% yet return less than that over the long haul. Generally speaking, a stock’s yield and its growth rate is a proxy for your total return over the long term.

      I hope that helps!

      Cheers.

  25. Abhi says

    Thanks a bunch DM, also I was looking at the spread sheet in Divident Discount tool kit and it has Expected Terminal Dividend Growth rate, could you please tell me whats that?

    • says

      Abhi,

      I’m guessing you’re speaking out the two-stage dividend discount model. The terminal rate is your permanent rate, which would be the same as the one rate you’d use in the one-stage model. The only difference with the two-stage is that you’re factoring in a more aggressive rate for the first 10 years.

      Cheers!

  26. Abhi says

    Thnx Jason. Please Pardon my lack of knowledge since I am trying to learn from the expert. For e.g lets take McDonald’s Stock. As i am writing this comment, its stock is $90.57. I am using the Dividend toolkit spreadsheet and I am trying to plug in the numbers.

    McDonald has Dividend Growth rate of 17% for the last 10 years(2003-2014) and going by the history i expect that it increases it dividend by 9-10% next year. But that would be too aggressive considering the headwind Mc is facing in China and its Q3 results hasn’t been that great. Let go with 6% Dividend increase for the next year. I factor in my Discount rate as 10%. That gives the one stage Intrinsic value as $90.10.

    For 2 Stage intrinsic value, the expected Div growth for McDonalds in the next 10 years, i put in as 8% since Mc Donald brand is pretty saturated in the market than what we had in the last 10 years. The terminal growth rate i put in as 5% though Mc Donald’s has free cash on hand and that gives me Intrinsic value of $90.00.
    Now I understand that this is all long haul guess that we are making based on the past. Just wanted to be sure am I on the correct path?

    Is that correct way that i am approaching this?

    Also i noticed Mc’s Debt/Equity is 111.04(yahoo finance) is that 1.11% of equity or 111 times equity??

    • says

      Abhi,

      It sounds like you’re on the right path there. I cannot answer a question in regards to growth rates for you, because that’s all subjective. What I think might be appropriate will likely be different from what you think, and vice versa. Valuing stocks is not a science and there isn’t a pinpoint accurate number you can come upon. The best one can do is reasonably estimate a fair value and try to buy in with a margin of safety.

      As far as debt/equity, the best way to know this is to look up the balance sheet and figure out the numbers for yourself. I find these numbers from sites like Yahoo incorrect all the time. But that number would indicate that MCD has about the same amount of long-term debt as it does shareholders’ equity.

      Cheers!

Join The Discussion!