Undervalued stocks and dividend yield pitfalls

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What is the dividend yield?

The dividend yield of a publicly traded company is a key figure. It calculates the relation between emitted dividend and the stock price, or to the employed capital. Arithmetically speaking this means:

100 % * dividend per share / share price = dividend yield in percent.

The value of the dividend is usually defined in the stockholders meeting. This is a defined payment per emitted share, e.g. something like 3 Euro per share. If the stock investor holds for example 10 shares of this company, he will receive 3 Euro times 10 shares = 30 Euro dividend. The actual dividend yield in percent for this particular stock holder depends on the buy price he paid for his shares. Let‘s assume, he bought the shares at 60 Euro per share and therefore paid 10 shares times 60 Euro = 600 Euro. In this case, the dividend yield in percent amounts to 100 % * 3 Euro / 60 Euro = 5 %.

Another stock holder, who bought the shares of the same company already at 20 Euro per share, will be happy to receive a dividend yield in percent of 100 % * 3 Euro / 20 Euro = 15 %. Since she has the same number of shares, she will receive the same absolute amount of dividend: 3 Euro times 10 shares = 30 Euro. However, the capital employed in this case is only 20 Euro times 10 shares = 200 Euro.

So both of our example investors have received the same 30 Euro of dividends, but the first investor has a much lower dividend yield in percent, since he employed much more capital in the first place. The dividend yield therefore makes a statement about the investment efficiency of the employed capital, but not about the absolute value of money that will get transferred to your bank account.

In this example we calculated the individual dividend yield for an investor who has already bought the dividend stock. If you use the current stock price for the same calculation, the resulting dividend yield would be yours, if you buy the stock for the current price. Since the current price of a dividend stock fluctuates, the according dividend yield fluctuates as well.

Why the dividend yield alone is not enough to analyze a company

The dividend yield doesn't have enough analytical power on its own:

• If the stock prices decrease (market conditions, bad company news, strange viruses mingling amongst us), the dividend yield will automatically increase. The more the stock price drops, the higher the dividend yield will get. The reason for the falling stock price is of importance here: if the company files for bankruptcy, a high dividend yield surely isn't a reason to buy the stocks. The dividend that flows into the calculation is taken from the last annual statement and therefore doesn't reflect the current situation.
• Some companies increase their dividends without paying them out of the current profits, but out of their equity capital. In this case the dividend yield increases as well, but the question if this is a viable investment, can only be answered after taking a thorough look at the financial data of the company.
• The past dividend does not make a statement about the future. It is possible, that the dividend will be cut or even omitted entirely. Happens surprisingly often.

What is an undervalued dividend stock?

An undervalued dividend stock can be identified on the one hand by a stock price, that undervalues the current financial situation of the company. On the other hand by a high dividend yield, but only if the current financial situation of the company looks promising. To find an undervalued dividend stock we therefore have to take a good look at the fundamental financial data. This is where balance sheet analysis comes into play.

How to find undervalued dividend stocks?

A series of key figures can provide insights, if a dividend stock is undervalued or not. A single yield or key figure alone is never sufficient. To obtain a more complete picture of the financial situation of the company, we need to take a close look at their assets and earnings. In order to do this we need the complete annual statement including balance sheet, profit and loss statement (PnL) and the cashflow report. Luckily for us, this data has to be published for publicly traded companies and is available usually directly on the company’s website under investor relations or at your preferred finance portal or broker. Considering this data, we are able to evaluate the necessary key data, that often are already calculated by finance portals as well.

Key figures for your dividend strategy

Since single numbers on their own for instance of the balance sheet do not have much significance, you have to set them into the right context, meaning, their relations to other numbers. Therefore, you set multiple values of the balance sheet into relation to each other and get an idea of the situation. Ideally, you should be able to understand the meaning of key figures and relations, instead of simply going through a list that someone else provided for you. To arm you with powerful knowledge, we are going to describe a few important relations and their key figures.

Balance Sheet Key figure: Golden Rule of Balance Sheet

The value of the fixed assets alone doesn‘t say much. Much more exciting is the question, if the fixed assets were financed for the long run. The fixed assets can be found on the left side of the balance sheet and stands for capital that is employed for the long term. This could be real estate that belongs to the company, production halls or the motor park. Long term employed capital should be financed for the long run, since it will take time until it generates money for the company.

To find out if that is the case, we will take a closer look at the right side of the balance sheet. Here we find the equity and the outside capital. The equity consists of investor‘s money and earned profits. The outside capital consists of liabilities, therefore it is mainly long term or short term borrowed money.

Now we will set the sources of funds (liabilities side) in relation with the fixed assets (asset side), because we want to know, if the fixed assets are standing on solid financial grounds.

Golden Rule of Balance Sheet I = equity / fixed assets >= 1

Golden Rule of Balance Sheet I = (equity + long term funds) / fixed assets >= 1

The Golden Rule of Balance Sheet I is more rigorous than the Golden Rule of Balance Sheet II, since it requires the fixed assets to be financed completely out of the equity. In the real world these companies are very rare, since most companies are financed with outside capital. If you are lucky enough to find such a dividend stock unicorn, that has financed the fixed assets out of equity, you can be quite sure that the management prefers sustainable thinking and tries to be as independent as possible. Certainly, outside capital taken from a bank for instance leads to a certain amount of dependence. If sales decrease or even a few bad years are coming along, banks are sometimes quick to stop providing money for these companies. A company that fulfills the golden rule I however is not bothered by this and can happily proceed to operate their business model.

The dynamic capital to cashflow ratio

The dynamic capital to cashflow ratio measures, how long it would take in theory to pay off the current liabilities with the current cashflow (debt repayment capacity). This key figure is particularly interesting, since it can point out financing problems.

Dynamic capital to cashflow ratio = outside capital/cashflow

The outside capital is on the liabilities side of the balance sheet and often the accruals are added to it as well. Accruals are unknown liabilities, which are likely to occur. Sometimes the liquid funds (e.g. bank balance, stocks) is subtracted from the outside capital in the above formula. The liquid funds are located on the asset side of the balance sheet in the liquid assets. If you subtract the liquid funds, you are calculating with the so called effective debt.

The dynamic capital to cashflow ratio is a number in years. If for instance you'll get 10.5 years as a result, then it would take the company 10.5 years to pay off their current liabilities with the current cashflow – provided the cashflow stays the same. The credit rating of a company is higher, the lower the dynamic capital to cashflow ratio is.

Is the dividend company profitable?

Since ideally the dividend is paid out of earned profits, we will take a good look at the profitability of the company. Being profitable means the company has made a profit or generated earnings. This is reported in the profit and loss statement (PnL) of the company. Here we can find results like EBIT and EBITDA. The first one depicts earnings before interest and taxes, while the second one stands for earnings before interest, taxes, depreciation and amortization. The EBITDA is particularly interesting, since tax and finance political values not included.

The art of balance tuning

Things like depreciations leave a lot of room for tuning the numbers of your annual statement. A depreciation is a calculated deterioration of the fixed assets (asset side of the balance sheet) and there are several legal possibilities to calculate it. Therefore these are only accouting losses and no money has changed hands. That's why you won't find the depreciations in the cashflow statement. For the profitability of the company the economical success is the crucial factor and not the ability to make the balance sheet look good. Therefore the EBITDA should be positive, which gives us a hint that the company is profitable. But what should the value of the EBITDA be like so that we know we have found a company that is very profitable and has a shining future? To answer these questions, we need to take again a closer look at some relations and key figures.

Return rate or Yield of a company

From a purely technical point of view a company is profitable, if it earned a profit of 1 Euro. If this company had employed a capital of only 0.01 Euro to obtain this result, then that's great. But if the company had employed 1 Mio. Euro, then there is surely a lot of room for improvement. We therefore realize, that an absolute value of the EBITDA alone does not say much about the rate of return of a company. To get this insight, we need to set a value from the PnL, for instance the EBITDA in relation to a balance sheet value, like the equity or the total employed capital. This is the return on equity (ROE):

Return on Equity (ROE) = Profit / Equity

The return on investment (ROI) is calculated using the total capital:

Return on Investment (ROI) = Profit / Total Capital

Of course you can also set the profit in relation to the sales, to get an idea of the efficiency of the business model. This is known as the return on sales (ROS):

Return on Sales (ROS) = Profit / Sales

A return rate provides insights on the efficiency of the employed capital. Ideally you want to employ as little money as possible, while earning a high profit. Small amount of work with high returns is the goal. These insightful calculations can not only be done with dividend stocks, but in an analogous way with real estate investments as well. That's why we are currently programming our investment analyzer, which will be released as beta version shortly.

Conclusion

Finding undervalued dividend stocks is possible, if you are willing to take a closer look at the financial reports of a company. Armed with knowledge and your calculator, you can get deep insights into the efficiencies of the employed capital, the business model, and even the mindset of the management. In this article we showed you key figures, that always should be considered together while analyzing a company. A single relation or key figure does not say much. Of course, our article is not exhaustive but from our point of view provides a useful tool set for your dividend stock analysis to get a first good look at the company's financial situation.

What are your favorite key figures? Tell us in the comments! :-)