My Simple Investment Criteria [Part 1]

I won't dig any deeper unless a stock meets these criteria

January 23, 2023

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Today I'll be sharing the first of 2 issues covering the simple criteria I look for in all my stock investments.

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Now, for today's piece:

My Quantitative Investment Criteria

Highlights

  • This is a list of quantitative criteria I use to find investments

  • I'll be covering Free Cash Flow, Dividend Growth, and more

  • Tell me how I did by using the new poll feature near the bottom of the issue

  • Stay tuned for next week's follow-up issue on qualitative criteria

Introduction

Today begins the first of 2 issues covering the simple criteria I look for in all my stock investments.

I'll begin by sharing some quantitative criteria I look for in a company when I'm considering investing.

I'll be covering:

  • Free Cash Flow

  • Dividend Growth

  • Dividend Payout Ratio

  • Shares Outstanding

  • Corporate Debt

Next week I'll be sharing qualitative criteria I use for investments – things you can see but can't put a number on.

Let's jump in!

Growing Free Cash Flow

Free Cash Flow is the cash left over after a company pays for its operating expenses and capital expenditures.

In other words, it's money the company has that's free of any obligation.

It can be used for dividends, paying down debt, investing for growth, and investing in other ventures.

I consider Free Cash Flow to be the most important metric when looking at a company to invest in.

If a company isn't growing its Free Cash Flow, then it can't afford to invest in growth or sustain its dividend.

10+ Years Of Uninterrupted Dividend Growth

I prefer companies with at least 10 straight years of dividend growth.

Normally the economic cycle of Expansion, Peak, Contraction, and Trough takes 4-10 years.

If a company can continue to raise its dividend through all segments of the economic cycle, it gives me greater confidence in management and the financial health of the business.

Dividend Payout Ratio <60%

The Dividend Payout Ratio is the measure of how much of a company's net income is paid out in the form of dividends.

If a company is paying too much of its net income by way of dividends, a few things can happen:

  • It won't have enough cash to reinvest in the business to grow

  • It won't be able to raise its dividend

  • It may have to cut the dividend in the future

A Dividend Payout Ratio under 60% gives the company room to grow its business and its dividend for years to come.

Decreasing Shares Outstanding

Decreasing share counts are a sign that a company is buying back shares, which you definitely want to see as an owner.

Why is buying back shares important?

If a company is buying back shares that means there are fewer shares available to the public.

Fewer shares mean every share is worth a bigger portion of the company and if you're an owner you want a bigger percentage of the company every time you buy shares.

Ex. Company A has 100 shares outstanding and you own 10 of them. 

Therefore, you own 10% of the company.

10 / 100 = 0.10 

0.10 x 100 = 10% 

Company A decides it will authorize a share buyback plan and buys back 10 shares. 

There are now only 90 shares outstanding but you still own your original 10 shares. 

Those 10 shares now represent an 11.1% ownership stake in the company.

10 / 90 = 0.111

0.111 x 100 = 11.1%

Conversely, if the share count is increasing, that means a company is diluting owners.

Companies will issue additional shares if they need to raise capital.

When new shares are issued that means existing owners now own less of a percentage of the company.

Ex. Company B has 100 shares outstanding and you own 10 of them. 

Therefore, you own 10% of the company.

10 / 100 = 0.10

0.10 x 100 = 10%

Company B decides it will issue 10 additional shares for purchase by the public in an effort to raise capital. 

There are now 110 shares outstanding and you still own your original 10 shares. 

Those 10 shares now represent an 11.1% ownership stake in the company.

10 / 110 = 0.909

0.909 x 100 = 9.09%

Not Too Much Debt

Companies that have too much debt will either fail or dilute owners in times of high interest rates.

Some companies take on immense debt to finance future growth, and that works during the years when the Federal Funds Rate is 0%

Unfortunately for those companies, 0% interest rates are no longer the case.

But that can be a good thing for you as an investor!

Higher interest rates force companies to be more calculated and cautious with investor funds.

This helps separate the mediocre companies from the well-ran companies with fortress balance sheets.

It's important to watch a company's debt levels and make sure they can reasonably pay back their debts.

I look at 2 metrics, the first of which is Cash Burn Rate.

To calculate the Cash Burn Rate, go to the company's earnings releases. 

Go to the Statement of Cash Flows from the prior quarter and see how much cash the company has on hand.

Do the same for the most recent quarter and subtract the 2 numbers.

Ex. Company A has $1,000 of cash on hand to start the year.

At the end of Q1, Company A has $900 on hand.

1,000 - 900 = 100

Company A is burning $100 per quarter, that's their cash burn rate. 

You can estimate that Company A will have no cash in 10 quarters without new funds being raised or profits being converted to cash reserves.

1,000 / 100 = 10

I also look at the Debt-To-Equity metric.

Debt-To-Equity (D/E) compares a company’s total liabilities with its shareholder equity.

To calculate this, divide the company's total liabilities by its total shareholder equity.

Both of these numbers can be found on the balance sheet.

Ex. Company Z has $10 worth of total liabilities and $50 worth of shareholder equity.

10 / 50 = 0.2

D/E = 0.2

This D/E of 0.2 means that the company has $0.20 worth of debt for every $1 of equity. 

Very favorable ratio.

Not all Debt-To-Equity ratios are equal though.

Many industries such as heavy machinery require a lot of debt upfront for equipment costs, and they make up for that by selling those heavy pieces of machinery at a high price.

Think of the company Caterpillar, they sell giant construction machines like bulldozers and cranes.

It costs a lot of money to make those machines, but they sell them at a very high price to compensate.

I like to target companies with a D/E below 2 and I find it most useful to compare the D/E ratios of companies within the same industry.

Final Thoughts

This issue was a short list of the qualitative metrics I look at before investing. It's meant to be my starting point before digging any further.

I use additional quantitative metrics in my deeper analysis but I prefer that a company meets these criteria before I spend any more time digging into it.

Next week I will spend some time digging into qualitative criteria that I look for when investing.

Thanks again for taking the time to read, happy dividend investing!

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This simultaneously amazes me and scares the shit out of me: 

New Episode Of The Dose Of Dividends Podcast!

This week I sat down with @ValueStockGeek! We talked:

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  • What 2022's performance means for the future of stocks, bonds, and gold •

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Disclosure: The contents of this newsletter are in no way intended to provide financial advice. I am not a licensed Financial Advisor. The opinions expressed in this newsletter are for informational, educational, or entertainment purposes only. I may buy or sell any positions mentioned at any time. I do not and will not encourage you to buy any specific investment security. Everyone has different investment goals and finances, and what works for me may not work for you. Investments of any kind carry risks that may result in partial or total loss of capital. You should contact a professional and conduct thorough due diligence before making any investing-related decisions. This newsletter may contain affiliate links and I may receive a commission from the usage of any affiliate links at no charge to the user.

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