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20 Quick Ways to Check a Company

Investing research can be overwhelming. This is especially true for novice investors; there are just so many metrics to consider, and they all relate to each other in a large and complex whole, so how can one make sense of a set of investments and compare them?

This article is meant to provide a quick organization viewpoint in regards to scanning dividend stocks. It’s not meant to be an all-inclusive guide on how to select a company, but it provides what I consider to be among the most important investing criteria, and how they relate to each other. Some businesses, such as financial companies and partnerships will require a different set of metrics, but these work well for a large collection of dividend stocks out there.

I have broken the metrics down into a few categories: Growth, Financial Strength, Dividend, Subjective Information, and Valuation. Growth metrics are a few ways of analyzing how quickly a company is growing. Financial Strength metrics show how strong a company’s balance sheet is. Dividend metrics are obviously important for those seeking dividends, but also important to gauge overall shareholder friendliness of the company and long-term stability. Subjective Information allows one to take into account non-quantitative aspects of the company, like strength of the moat and quality of the management. Lastly, Valuation metrics are a tool to understand how much investors are currently willing to pay for the company, and this will generally depend on the other metric categories like growth, financial strength, and subjective information.

Generally, things like solid growth prospects, strong balance sheets, and positive subjective information will lead to higher reasonable valuations for a company. So when analyzing a company, I look to find a company with decent growth prospects, a strong financial position, positive subjective information, and shareholder friendly management, and then I look to see if the valuation is reasonable given this total information.

Growth:
Net Income Growth
Revenue Growth
EPS Growth
FCF compared to Net Income
Return on Equity

Financial Strength:
Debt/Equity
Interest Coverage Ratio
Goodwill/Equity
Current Ratio

Dividend Information:
Dividend Yield
Dividend Payout Ratio
Dividend Growth
Share Repurchases

Subjective Information:
Business and Industry Prospects
Economic Advantage
Management Quality

Valuation:
Price-to-Earnings (P/E) Ratio
Price-to-Free-Cash-Flow (P/FCF) Ratio
Price-to-Book Value
Market Capitalization

Growth

A company can grow in many ways, so looking at a variety of growth metrics is important.

Net Income Growth
Income is the bottom line that business owners are after. Companies operate to bring in profits, and profits ideally grow over time. It’s useful to look at net income growth over 3-year, 5-year, and 10-year periods to get an idea of what kind of long-term growth prospects this company may have, and how the trends are changing (is growth slowing or accelerating, or neither?)

Revenue Growth
In many cases, it’s important to look for revenue growth as well. If a company is growing net income but not revenue, it means they are becoming more efficient and therefore increasing their profit margins, but this can only go so far. For sustained growth of net income, sustained revenue growth is required.

EPS Growth
To investors, growth of earnings-per-share is typically even more important than net income growth. If a company grows its net income, while using some of its money to repurchase its own shares, then EPS will grow faster than net income. If, on the other hand, a company is diluting its shares by issuing more shares than it is repurchasing, EPS will grow more slowly than net income. In addition, EPS may be growing even if net income is flat or decreasing, so it’s important to look at both per-share metrics and total company metrics.

FCF compared to Net Income
A company that maintains solid free cash flow numbers is a sign of health and economic advantage. If a company can maintain profitability and growth with minimal capital expenditure, then it’s likely performing quite well. I look for operational cash flow to be substantially higher than net income, and for free cash flow to be either higher than net income, or at least comparable to it, in most investments. It depends to a certain extent on the industry.

Return on Equity (ROE)
When you divide net income of a company by their total shareholder equity, you get return on equity. Typically, higher returns on equity are a sign of competent management and a profitable business, because they are bringing in a lot of income for each dollar that is on the balance sheet. One must be careful, though, because a bad balance sheet can sometimes boost returns on equity. If a company has a large amount of liabilities compared to assets (and therefore a small amount of shareholder equity), then ROE will seem quite high. So it’s important to look at the whole picture, and compare ROE to financial strength metrics.

Financial Strength

A company that is in good financial shape reduces risk, provides opportunity, and shows management responsibility. All else being equal, a company with a strong balance sheet is worth more than a company with a weak one.

Debt/Equity
Debt/Equity is an important metric. Long-term Debt/Equity is calculated by taking the total amount of long-term debt and dividing it by the amount of shareholder equity. The lower the number, the less debt the company has compared to equity. I prefer companies with less than 0.5 debt/equity ratios, or at least less than 1.0 debt/equity ratios, but it will vary to a certain extent in some industries. Companies that necessarily have large amounts of capital expenditure will usually have substantial debt levels.

Interest Coverage Ratio
If a company holds debt, it’s paying interest on that debt. A company with a lot of debt will be paying a lot of interest, but other factors matter too. A company with a strong balance sheet and a good credit rating generally pays lower interest rates than a weaker company, and so a metric is needed to sort out different situations. If you take income before taxes and divide it by the amount the company pays in interest over that time period, you’ll get the interest coverage ratio. I typically look for companies with an interest coverage ratio of at least 3, but prefer to see it over 8 or more.

Goodwill/Equity
Some assets are called “goodwill”, which is an accounting asset rather than a real one. When a company pays more for a company than its book value, they put the remainder on their balance sheet as goodwill, and management is responsible for deducting from it as appropriate. If a company has a lot of goodwill, it can artificially lower metrics like debt/equity. On the other hand, goodwill isn’t necessarily a bad thing if it is accurate. Some companies, especially those prone to making acquisitions, will naturally hold more goodwill than others. Dividing the total goodwill by the total equity shows what percentage of equity consists of goodwill. All else being equal, it’s optimal to look for fairly low or moderate levels of goodwill.

Current Ratio
The current ratio is calculated by taking total current assets (cash, short-term investments, receivables, etc) and dividing by total current liabilities (payables, short-term debt, etc). This should typically be above 1, and I prefer to see a higher number in smaller companies.

Dividend Information

To dividend investors, researching the dividend is obviously of immense importance. One wants a significant dividend yield, a growing dividend, but a payout ratio that is low enough to increase the likelihood that the dividend remains safe and growing.

Dividend Yield
To calculate the dividend yield, take the amount that the company pays in dividends per share each year and divide that amount by the share price. Typical dividend investments typically pay 2.5% to perhaps 7%, with 3-5% being a pretty good area. Yields under that are pretty low, and yields above that may be value traps.

Dividend Payout Ratio
An unsustainable dividend is not a very useful dividend. Divide the total yearly dividend by the EPS to get the earnings payout ratio. This represents the percentage of earnings that the company is paying to shareholders as dividends. It’s also worthwhile to divide the total yearly dividend by the per-share free cash flow to get the FCF payout ratio. Ultimately, it’s cash that determines dividend sustainability.

Dividend Growth
Some companies pay the same dividend each year, some companies grow or reduce their dividends erratically, while others successful grow their dividend year after year. Seeing dividend growth trends can help determine future growth of your passive income and your yield on cost.

Share Repurchases
Some companies repurchase their own shares, which means the existing shares that a shareholder owns are worth a greater percentage of the company (or the company can eventually issue the shares again for an acquisition). Companies typically also issue shares to executives for compensation. Looking at the net share repurchases of a company (repurchases minus issues), shows how much money the company is spending on share repurchases. It’s sometimes useful to compare this amount to how much they are paying in dividends. Share repurchases will boost EPS and fuel dividend growth, but can sometimes be used irresponsibly.

Subjective Information

This is what separates humans from machines. Anyone can plug in the above numbers (and they should), but it takes someone with insight to figure out the rest. This is what separates good investors from mediocre ones, along with discipline and patience. This part of the investment process takes the most work.

Business and Industry Prospects
For long-term investments, it usually makes sense to pick a business that is in an industry that is not going to go away any time soon. A healthy and growing industry makes it easier for a company in that industry to grow and increase profitability. Likewise, even a great company in a struggling industry may find itself in trouble. Even the world’s best horse-and-buggy company will run into trouble if everyone starts driving cars. Sometimes an industry may seem to be in bad shape, but the long term is what’s important. Sometimes great values can be found in industries that are currently out of favor but that have great long-term potential.

Economic Advantage
Some companies have advantages over others that separate them and allows them to achieve and maintain impressive levels of profitability. If companies compete against each other without economic advantages, they are essentially offering commodity products and services, and it often leads to the result that they will not be quite as profitable or have as much staying-power, as those that do have strong advantages. The popular explanation is that an economic advantage is a company’s moat, keeping competitors away with little work.

Examples of Economic Advantages include:
Scale: If a company is larger than others, it likely has more purchasing power, a more effective and efficient distribution network, and the ability to buy-out or out-spend competitors. Companies have trouble competing against scale because they lack scale themselves, and they cannot achieve scale unless they compete well, so it’s a vicious cycle.

Switching Costs:
When it is difficult for a customer to switch to competitor’s product or service, they likely will not. It’s a hassle to change banks, to change infrastructure, and to change computer systems.

Regulation:
Some companies operate in such a way that they essentially have a regulated monopoly. Their risks and rewards are reduced and investments can potentially be more predictable.

Intangible Property: People are willing to pay a little more money for the same product or service when they feel trust towards a brand. In addition, when a person is selecting a product or service seemingly at random, they are likely to pick one they are familiar with. Brand strength is an intangible benefit to many companies. Patent shields are also powerful defenses. When a company can patent its product or service, it keeps competitors away temporarily and allows high levels of profitability.

Management Quality
Lastly, it’s worthwhile to look at management quality. How long has the current CEO been running the company? How have they performed? How much of the company do the executives own? What is the company culture like? Having an outstanding group of individuals running a high-quality business can do wonders for your portfolio.

Valuation

The valuation of a company is the snapshot of what investors are willing to pay for this business at the current time. Fair valuation depends to a large extent on other metrics, and must be considered alongside them.

Price-to-Earnings (P/E) Ratio
The P/E ratio is the price of a share divided by the earnings-per-share. Because price is measured in dollars, and earnings are measured in dollars per year, the units for P/E are measured in years. A higher P/E ratio means that investors are currently paying more per unit of earnings, while a lower P/E means investors aren’t willing to pay very much per unit of earnings. Typically, my investment purchases have a P/E of between 10 and 20 with a few exceptions, and it varies based on a number of factors.

Price-to-Free-Cash-Flow (P/FCF) Ratio
P/FCF is similar to P/E, except free cash flow per share is substituted for earnings. Free cash flow is the total amount of cash brought in by operations minus the amount of cash that was used for capital expenditure. It can sometimes be more truthful than earnings, but tends to be more volatile because management may spend more in capital expenditure in some years than others. Monitoring both income and cash flow is important to get a good grasp on how the company is really performing.

Price-to-Book Value
When you take a company’s total assets and subtract their total liabilities, you get the total shareholder equity, or book value. Book value per share is the total equity divided by the total number of shares. Tangible book value is the same, except it excludes intangible assets such as goodwill. If the company were to go out of business, the tangible book value is the theoretical amount each share would be worth. Different industries have different reasonable book values, because some types of businesses require more assets than others (think manufacturers vs. software).

Market Capitalization
Market capitalization is the total number of shares multiplied by how much each share is currently worth. Theoretically, this is how much the market has decided the entire company is worth. It’s worth looking at, because investors often look to have a mix of big companies and smaller ones.

Conclusion

In conclusion, it takes a lot of work to thoroughly analyze a company. These metrics are a good start, and one will also need to delve into their annual reports, compare the company with competitors, research investing and public commentary on the company, and assess risk and potential growth catalysts.

When looking for a company to invest in, I look for a strong balance sheet, decent growth prospects, competitive advantages, a positive industry, shareholder friendly and competent management, and solid dividend information. I focus on long-term potential and total shareholder return.

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Comments

  1. Matt,

    This is a great summary…one that I’ll be referencing for awhile in the future to ensure my research is thorough!

    One other quick way to begin your research, that encompasses many of the areas above, is to use Morningstar’s Credit Rating. I glance at that first as a starting point for my research. Thanks again,

    DivPartisan

  2. Ian Thompson says:

    I really enjoyed this posting as it provides a great summary of the key metrics in analyzing a company.

    Price to book is often used as a measure of relative value and I have often questioned the number. I believe a ratio closer to 1 is a better investment than a ratio greater than one.

  3. Good post. I think another important metric is multiple-year PE, say 3 or 5 years (atleast for cyclical companies).

  4. Dividend Partisan,

    Morningstar is a great resource. It’s useful both as a place to find metrics and statistics, and also to find their subjective take on things.

    Morningstar basically uses these metrics or similar ones to calculate their credit ratings anyway, though. Companies that have low debt levels, high interest coverage ratios, and lower goodwill tend to have high credit ratings from morningstar- and they also take into account subjective information because an economic moat can boost financial stability. I don’t recall ever doing looking up or calculating these metrics and then being highly surprised by a Morningstar credit rating in comparison to those metrics.

    Ian,

    A reasonable price-to-book ratio depends on the industry. For some industries, I expect price-to-book ratios to be around 1. For other industries, price-to-book can be somewhat higher due to the nature of the business. So I compare price-to-book on an industry basis rather than across the board.

    Defensiven,

    I agree. This certainly isn’t an end-all list of metrics, just the 20 I thought were the most useful. It’s definitely open for debate or improvement.

  5. Simply excellent post! I think you pretty much touched everything. Your attention to detail is admirable, and something I need to emulate more often.

    Thanks!

  6. Thanks for the pearls of wisdom . This is a very well thought out informative article . I would love to read your deeper thoughts on valuation after having read this post I am sure they would be enlightening .

  7. Thanks for this awesome post Matt. Very useful tips to check the company…

  8. Great post! I sure will keep all this in mind in my future analysis. My current method is not this elaborated. Thank you for this, and for a great blog!

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