****Investment Valuation Ratios

This ratio analysis tutorial looks at a wide array of ratios that can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its valuation.

However, when looking at the financial statements of a company many users can suffer from information overload as there are so many different financial values. This includes revenue, gross margin, operating cash flow, EBITDA, pro forma earnings and the list goes on. Investment valuation ratios attempt to simplify this evaluation process by comparing relevant data that help users gain an estimate of valuation.

For example, the most well-known investment valuation ratio is the P/E ratio, which compares the current price of company's shares to the amount of earnings it generates. The purpose of this ratio is to give users a quick idea of how much they are paying for each $1 of earnings. And with one simplified ratio, you can easily compare the P/E ratio of one company to its competition and to the market.

The first part of this tutorial gives a great overview of "per share" data and the major considerations that one should be aware of when using these ratios. The rest of this section covers the various valuation tools that can help you determine if that stock you are interested in is looking under or overvalued.

Table of Contents

1) Investment Valuation Ratios: Introduction

2) Investment Valuation Ratios: Per Share Data

3) Investment Valuation Ratios: Price/Book Value Ratio

4) Investment Valuation Ratios: Price/Cash Flow Ratio

5) Investment Valuation Ratios: Price/Earnings Ratio

6) Investment Valuation Ratios: Price/Earnings To Growth Ratio

7) Investment Valuation Ratios: Price/Sales Ratio

8) Investment Valuation Ratios: Dividend Yield

9) Investment Valuation Ratios: Enterprise Value Multiple

Dow Theory - Market Phases

Dow Theory - Market Phases

Primary movements have three phases. Look out for these general conditions in the market:

Bull Markets

Bull markets commence with reviving confidence as business conditions improve.
Prices rise as the market responds to improved earnings
Rampant speculation dominates the market and price advances are based on hopes and expectations rather than actual results.

Bear Markets

Bear markets start with abandonment of the hopes and expectations that sustained inflated prices.
Prices decline in response to disappointing earnings.
Distress selling follows as speculators attempt to close out their positions and securities are sold without regard to their true value.

Dividend Yield

Dow believed that stocks yielding below 3.5 percent were over-priced "except there be some special reason." Richard Russell analyzed the dividend yield on the Dow from 1929 to 1959 and found that the market tended to reverse when yields had fallen to between 3 and 4 percent.

Since the 1960s the dividend yield on the Dow and S&P 500 has declined to around 2 percent. We should be careful not to leap to the conclusion that the market is way over-valued. Examine the S&P 500 chart below and you will observe that the Dividend Payout Ratio declined over the same period, from 60 to 30 percent.



Companies are retaining a higher percentage of earnings, preferring to return capital to stockholders by way of share buy-backs rather than by way of dividends. This favors investors who prefer the enhanced earnings growth offered by share buy-backs, without the tax implications associated with dividends.

We should therefore switch our focus to earnings yield, rather than dividend yield, in order to avoid any distortion. An earnings yield of below 5.0 percent would offer a similar over-bought signal to a dividend yield of less than 3.5 percent (0.035/0.7=0.05). This translates to a price-earnings (PE) ratio above 20. I use a PE ratio above 20 to signal that a bull market is entering stage 3.

Perfect Your Market Timing
Learn how to manage your market risk.

Volume Confirmation

Increased volume on declines and dull activity on rallies provide additional evidence of an overbought market. Conversely, lack of activity on declines and increased volume during rallies indicate an oversold market. See Volume Patterns for further detail.

http://www.incrediblecharts.com/technical/dow_theory_market_phases.php

Nice way of depicting total shareholder returns

Calculate investor ratios

Investor ratios are used by existing and potential investors of mostly publicly listed companies.  They can be obtained or calculated where necessary from publicly available information.


EARNINGS PER SHARE (EPS)

This is a popular profitability statistic used by financial analysts.  'Earnings available for distribution' is bottom-line net profit attributable to shareholders after all other costs have been deducted.  Many remuneration packages are linked to EPS growth.

EPS = Earnings available for distribution /  Number of shares in issue



PRICE/EARNINGS (P/E) RATIO

The P/E ratio applies to publicly listed companies and is a key measure of value for investors.  A P/E ratio of 10 means that investors are willing to pay 10 times previous year's earnings for each share.  Generally, the higher the P/E ratio, the higher the growth prospects perceived by investors.

P/E ratio =  Share price / EPS



DIVIDEND YIELD

This measures cash paid to shareholders as dividends.  This should be compared to capital growth, to measure the overall return to shareholders.

Dividend yield = Dividend per share / Price per share

Mature businesses tend to have higher dividend yields than young businesses, as the latter reinvest most of their earnings.  Investors looking for high-income investments choose high-dividend yield companies.



DIVIDEND COVER

This follows a similar principle to 'interest cover'.  It measures how many times a business can pay its dividends from its earnings.  It is used as a measure of dividend risk.

Dividend cover = EPS / Dividend per share

It also measure the proportion of profits retained in a business versus paid out as dividends.  For example, a dividend cover 3 times shows that a business has paid one third of its profits to shareholders and retained two-thirds.  Retained earnings are an important source of finance and therefore dividend cover is often high.

Use investor ratios to see if business goals are aligned with investor goals.


Related posts:

Measuring Business Performance

Measure Profitability

Measure short-term solvency and liquidity

Measure long-term solvency and stability

Calculate investor ratios

Evaluate a business using ratios

Estimate the value of a business

Do Dividend Plays Pay?

PERSPECTIVE | 12 MARCH 2010

Do Dividend Plays Pay?

By Aw Jie Sheng  

Dividends matter and they matter a lot! Had you bought Singapore Post at the start of 2005 and held it till the end of February this year, inclusive of dividends, it would have compounded at 9.4% over the 5 odd years, against the Straits Times Index’s 5.6%.

During that time frame, Singapore Post’s management had been very generous, rewarding a total $0.357 per share to its shareholders. Stripped of those distributions, Singapore Post would have lagged the market badly, compounding at only a paltry 3.4%.

This is not a case of cherry picking. In fact, a recent Citi Investment Research report noted that in the past 10 years, equities in Asia ex-Japan have generated a compounded total return of 5.9% per annum in US dollar terms, 46% of which came from dividends.

Dividend Matters


Some formulae are in order before proceeding further. Dividend yield, the most basic metric, is calculated by dividing total dividend per share paid out during a full financial year over the stock’s current market price.

Dividend payout ratio (DPR) is more instructive as yield tends to fluctuate depending on the time of the day. This is calculated by dividing total dividend per share paid out during a full financial year over that respective year’s earnings per share (EPS).

Singapore Post, for example, paid out a total of 6.25 cents in dividends per share, when EPS was 7.7 cents in FY09. Be sure to exclude special dividends as they are one-off. Dividend payout ratio works out to about 0.8, which means 80% of FY09 profits were returned to shareholders. The importance of the dividend payout ratio will be elaborated later.

There are companies, particularly those of blue chip pedigree, that have a formal dividend policy stating the percentage of operating or net profit to be paid out. This can be found under the CEO/Chairman’s statement section of the annual report.

Even though a dividend policy is a legally binding commitment, companies that have one loathe changing it, as a downward revision or omission of dividends generally signals financial woes.

Finding Dividend Plays


To be able to consistently return profits to shareholders requires disciplined management as well as strong cash flow on the company’s side. These companies tend to be larger and/or more mature and are found mainly in the banking and finance, consumer staples, utilities and energy sectors.

Those that do have consistent and high dividend payout ratios – so called dividend plays – are likely past their growth phase. The stability in their earnings is generally accompanied by lower levels of R&D and capital expenditures. This is where we return to the dividend payout ratio.

Take the company’s return-on-equity (ROE) and multiply it by the earnings retention rate, which is one less the dividend payout ratio, and you will get the sustainable growth rate (SGR).

Again using Singapore Post as an example, based on FY09’s ROE of 59.2% and earnings retention rate of 18.8%, its sustainable growth rate works out to around 11.1%.

The sustainable growth rate is helpful in gauging whether a company’s growth plan is realistic based on its profits but it will not tell you whether a company has the opportunity to grow.

In this instance, if the opportunity exists and should Singapore Post want to grow its FY09 earnings by more than 11%, it would have to increase its net profit margins (this increases ROE) or fund future investments with debt or the issuance of new stock.

Books To Read


Modestly named “The Ultimate Dividend Playbook” by Josh Peters and “The Future for Investors” by Jeremy Siegel are great books to read for ideas and strategies on investing in dividend plays.

Peters’ book is very comprehensive and provides a detailed explanation on how to select and formulate a portfolio comprising of dividend plays, and the underlying mechanics. Be forewarned “The Ultimate Dividend Playbook” might be too textbook-ish for some and that it is focused mainly on American companies.

Siegel’s more readable account is a must-read for investors worried about the how the impending demographic age wave in developed world would impact future asset returns. While repeating his argument that common stocks are the best asset class in the long run, he highlights the importance of dividends and stock valuations as well as including international stocks in your portfolio.

For non-bookworms, the table below lists a few companies with a history of consistent dividend payments as well as relatively high yields. As usual, more research on the reader’s part should be done before investing.


*As of 10 MARCH 2010 Noon

http://www.sharesinv.com/articles/2010/03/12/dividends-pay/

Dividend-paying companies: major shareholders must be willing to share their profits with their investors through good dividend payments.

Wednesday March 24, 2010

Dividend-paying companies

Personal Investments - By Ooi Kok Hwa

Despite investing in profit-making companies, a lot of investors have been complaining that they are not getting the desired returns from the companies that they have invested in.

One of the main reasons is that these companies usually pay very low dividends or no dividends to their investors.

Hence, even though these companies make good profits from their businesses, they are not sharing the profits with their minority investors.

Companies that pay good dividends to their investors imply that the major shareholders of these companies are willing to share their wealth with minority investors.

Given that minority investors have no control over these companies, they have only two sources of returns from their investments, namely 

• dividend returns and 
• capital gains.

If the companies refuse to reward their investors with good dividends, then investors need to make sure that they buy low and sell high in order to get capital gains.

Warren Buffett proposes one concept, which is called the one-dollar premise - for every dollar profit that a company makes, it either pays one dollar dividend to its shareholders or if that dollar is being retained, it needs to bring additional one dollar market value.

Companies with good management will always try to maximize the wealth of their investors.

The following table will show the importance of dividends to an investor.

Assuming you have invested in Company A with an average cost of RM15.

Company A generates earnings per share (EPS) of RM1.00 with price-earnings ratio (PER) of 15 times and pay out 80% of its profits as dividends or dividend per share of RM0.80.

Hence, with the purchase price of RM15, the dividend yield (DY) is 5.3%.

We also assume that Company A has a constant PER of 15 times and dividend payout ratio of 80% for the next 20 years.

Annual growth rate of EPS is 8% based on our country’s average nominal GDP growth rate of 8%.

For the first 10-year period, given that our original cost of investment is fixed at RM15, our dividend yield will be getting higher and higher.

For example, first year DY of 5.3% is computed based on DPS of RM0.80 divided by RM15.

And second year DY of 5.8% is calculated based on DPS of RM0.86 (RM0.80 x 1.08) divided by the same original purchase price of RM15.0.

As the company’s businesses continue to grow and generate higher profits, as long as the company practices a fixed dividend payout policy (our example is based on a fixed dividend payout ratio of 80%), investors’ DY will increase.

At Year 10, given that our purchase price remains the same at RM15, with a DPS of RM1.60, our DY is 10.7% (1.60/15.0).

Thus, the average DY for the first 10-year period is 7.7%.

Coupled with the annual capital gain of 8% (the share price has grown by annual growth rate of 8% from RM15 to RM29.99), investors will generate an annual total returns rate of 15.7% (7.7% + 8%)!

If we keep this stock for another 10-year period, our next 10-year annual total return is 24.7% (16.7% + 8%)!

From here, we can see that if we have invested in good companies that always reward their investors with very high dividend payments, our returns will be huge if we hold it long term.

Normally, consumer-based companies and companies that do not need high capital expenditures will be able to reward shareholders with good dividend payments.

Besides, major shareholders must be willing to share their profits with their investors through good dividend payments.

Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.

http://biz.thestar.com.my/news/story.asp?file=/2010/3/24/business/5919730&sec=business

Also read:

*****Long term investing based on Buy and Hold works for Selected Stocks

Dividend Yield Investing - Stock Selection is still the Key

Why Stocks That Raise Dividends Trounce the Market

There are many different approaches to investing, some of them successful.

But few attain the time-tested success of investing in stocks that consistently raise dividends. And there’s no doubt these stocks have produced astonishing returns, decade after decade.

Unbiased research shows stocks that raise dividends trounce the market, while stocks that simply pay dividends roughly match the market. In what I suppose is an obvious corollary, these stocks historically beat the snot out of stocks that don’t pay dividends, without breaking a sweat between punches. It’s really been easy for them.

OK, let’s run through the research numbers first, then move on to the more interesting discussion of what might be firing them up.

A well-known study by Ned Davis Research shows that from 1972 through April 2009 (the latest data I found) companies with at least five years of dividend growth, and those initiating dividends, punched up average yearly gains of 8.7%, compared with 6.2% for the Standard & Poor's 500.

Companies that maintained steady dividends also gained 6.2% annually, same as the market, but well below what dividend raisers scored.

And non-dividend payers? Lightweights. Beaten down to under a measly 1% a year. Right, under 1% a year for over 36 years. Same story for stocks that cut or eliminated dividends.

In another study, using a different group of stocks, time period and performance measure, AllianceBernstein researched the largest 1500 stocks by market capitalization from 1964 to 1999.

Results? In the year immediately following a dividend increase, dividend raisers’ average total returns were 1.8 percentage points higher than stocks that did not raise dividends.

Compound that over a decade or two of dividend hikes and you can head for the Porsche dealership. (Think I’m kidding? Over 15 years, an extra 1.8 percentage points pops nearly $90K more out of a $285,000 stock portfolio. You don’t have to spend it on a Porsche. But you could.)

Want some more recent numbers, from stocks with decades of dividend increases already under their belt?

Standard and Poor’s research through the end of 2009 shows their Dividend Aristocrats, stocks with at least 25 years of dividend increases, beat the S&P 500 over the trailing 3-years, 5-years, 10-years and 15-years.

And the beating was another knockout, ranging from as ‘little’ as two percentage points annually to as much as nearly five percentage points, depending on the time frame.

So it’s abundantly clear these stocks have better returns. Much better returns.

But why does dividend growth achieve such superb performance? And should investors even care why? After all, more money is more money and that Porsche is still a Porsche.

My opinion? I think there are at least three reasons, and many investors could likely benefit, if they care to look at them.

1.  First, it takes an outstanding business to increase dividends for decades, and outstanding businesses are often outstanding long-term investments. Weak businesses simply can’t and don’t raise dividends for decades.

• So if it’s true, like I think it is, that dividend increases and higher stock prices are both caused, in part, by strong businesses, then it’s vital to understand and monitor dividend-growth companies’ underlying business strength. 
• That’s why you see successful investors evaluating these companies’ revenues, earnings, cash flows, debt levels, returns on capital, stock valuations, and so on, rather than just jumping on the dividend.

2.  Second, I think it’s also likely that a series of dividend increases, in and of itself, eventually helps pull a stock price up.

• After all, if share prices did not follow dividends upward, over time these stocks would end up with monster double-digit yields. 
• But that doesn’t happen because if a yield gets higher than investors think the good health of the business justifies, they buy more of the stock until the yield reverts back down to a more normal range.

All other things equal, there's simply more buyer demand for Johnson and Johnson (JNJ), McDonald’s (MCD), Procter and Gamble (PG) and other outstanding businesses (name your choice) at 4% yields than at 2% yields, so the stock prices move in response.

Of course, all other things aren't always equal. Stock prices are messy, impacted by companies’ outlooks, the economy, market conditions and so forth. 

• But over time, yields that grow too high on healthy stocks revert to normal levels through the mechanism of buyers bidding up stock prices.

3.  Finally, in all that market messiness, investors who stick with a dividend growth strategy enjoy a powerful statistical advantage that amplifies their stock picking.

• This advantage is something statisticians call “baseline probabilities.” 
• To illustrate, suppose a fisherman can choose either of two nearly identical lakes. But one lake has two big fish and eight little fish in it, while the other has the opposite: eight big fish and two little ones.
• At any level of skill and experience, the fisherman’s chances of landing big fish are much better at the second lake. That’s the idea of baseline probabilities. 
• And research studies show there are lots more big fish in the pool of dividend raisers than in the other pools, especially the pool of stocks that don’t pay dividends, filled with so many little fish its average returns approach starvation.

All that said, a dividend-growth strategy isn’t for everyone. (It’s only for people who want to make money … kidding, just kidding!)

For example, skilled traders, technical analysts and investors who’ve simply developed unique expertise in other areas of the market certainly might decide that dividend growth is irrelevant to their investing approach.

As might those who believe corporate America brims with budding Warren Buffetts, all doggedly toiling away at brilliant but so far unrewarded capital allocation programs that make far better use of company cash than dividends would.

And on that note, oddly, some investors seem to delight in arguing that dividend raisers are inferior businesses and, despite the numbers, inferior investments. This, because finance theory says ever-higher dividends waste capital these companies could reinvest back into their business, as non-dividend payers do.

I say “oddly” because the most rudimentary logic tells you that if dividend raisers as a group were capital wasters, and non-payers were capital multipliers, the market wouldn’t reward the raiser-wasters with such monumentally higher returns.

For an in-depth look at the pros and cons of dividends, one that generated a geyser of often coherent comments, check out David Van Knapp’s Seeking Alpha article “Why I Love Dividends.”

And for profiles and analyses of a number of dividend-growth stocks, click thisMore Articles link and take your pick.

Finally, investors who prefer ETFs to stock picking might look at the Vanguard Dividend Appreciation ETF (VIG). VIG’s total returns and dividend reliability have outperformed both the market and popular, higher yielding dividend-growth ETFs.

References and Links

Kiplinger Magazine, “Stocks That Pay Rising Dividends,” August 2009.

AllianceBernstein, “Why Dividends Matter,” November, 10, 2004.

Seeking Alpha, “Dividend Aristocrats: A Comprehensive View,” by David I. Templeton, January 22, 2010.

Additional acknowledgements: Thanks to all the Seeking Alpha authors and commenters who posted data and opinions that helped inform this article.

http://seekingalpha.com/article/193345-why-stocks-that-raise-dividends-trounce-the-market

Dividend Yield

Dividend Yield

The yield figure published in the newspapers is usually the historical one.

Analysts will often provide forecasts for dividends in terms of earnings per share (EPS) and thus the forecast yield can then be calculated. Forecast can, of course, go wrong, and consequently there is some risk in relying upon them.

WHY IT IS IMPORTANT

Yield, after the price/earning ration (P/E), is one of the most common methods of comparing the relative value of shares.

The majority of investors like to see a cash income from their shares, althoug to some extent this is a cultureal thing. There are more companies in the U.S., for example, that pay no dividends than in the U.K.

HOW IT WORKS IN PRACTICE

Yields can be compared against the market average or against a sector average, which in turn gives you some idea of the relative value of the share against its peers.

Other things being equal, a higher yield share is preferable to that of an identical company with a lower yield.

The higher yield share is cheaper.

In practice of course, there may well be good reasons why the market has decided that the higher yielder should be so - possibly it has worse prospects, is less profitable, and so on. This is not always the case; the market is far from being a perfectly rational place.

AN ADDITIONAL FEATURE OF YIELD (unlike many of the other share analysis ratios), is that it enables comparison with cash.

You can compare the yield from the interest rate in a bank without capital risk with the yield on shares, which are far riskier. This produce a valuable basis for share evaluation.

If, for example, you can get 4% in a bank without capital risk, you can then look at shares and ask yourself how this yield compares - given that, as well as the opportunity for long-term growth of both the share price and the dividends, there is plenty of capital risk.

TRICKS OF THE TRADE

Care is necessary, however, because unlike banks paying interest, companies are under no obligation to pay dividends at all.

Frequently, if they go through a bad patch, even the largest, most well-known household name companies will cut dividends or even abandon paying them altogether.

So, share yield is greatly less reliable than bank interst or government stock interest yield.

Despite this, yield is an immensely useful feature of share appraisal. It is the only ratio that tells you about the CASH RETURN TO THE INVESTOR, and you cannot argue with cash. EPS, for example, is subject to accountants' opinions but a dividend once paid is an unarguable fact.

Yield and price/earnings ratio (P/E)

Yield and price/earnings ratio (P/E)

Yield represents the historical annual dividend income paid by the share as a percentage of its current price. P/E shows how many years of current earnings are represented in the current price. Both of these ratios will therefore fluctuate with the price of the share - P/E in direct proportion and yield in inverse proportion.

These are the two most common ratios used by investors and market commentators in evaluating a share as a potential investment, both on its own merits and as a comparison with other shares. For this reason they are widely quoted in the press and almost every serious newspaper will show these figures alongside the price of each share in the listings.


COMMON MISTAKES

1. Believing that share price alone is an indication of the value fo the share

It seems logical to believe that shares for company A, with a share price of $200, are twice as expensive as those of company B, with a share price of $100. This is completely incorrect. The share price alone tells you almost nothing about the share, which is why P/E is so critically important.

Suppose in the above example, A has a P/E of 12 and B a P/E of 24. Now you can see that in fact B is twice as dear as A, even though it has half the share price. It means that collectively, investors have decided that it is worth paying 24 years' earnings for B but only 12 years' earnings for A. This does not mean that the collective market view is right or wrong, in that a higher P/E is better or worse than a lower one. That is a matter for the individual to decide for him- or herself.

What we are doing when using P/E is relating the price to some other fact about the company, in this case to earnings. Similarly, yield relates the price to the annual dividends paid. There are several other measures that relate the price to something about the share, examples, being assets (P/B) and sales (P/S). It is really only by reference to these that one share can be compared with another to ascertain which is cheaper or dearer.

2. Thinking that the yield will apply in future

In most cases, the yield figures shown in papers are historical. The exact method varies between papers, but generally it is based on taking the last year's dividends paid, dividing by the share price, and expressing the result as a percentage. But it must be borne in mind that no company is obliged to pay dividends at all.

3. Assuming that yield figures will always be sustainable

If you look through the tables, you can occasionally discover shares that appear to give enormous yields like 20% - which, on the face of it, seems to be a fantastic investment. But if you look behind the figures at announcements from the company, you will very likely find that it is going through a bad time and will probably cut, or eliminate, its dividend in the future. The huge historical yield appears only becasue the share price has collapsed following the bad news, and a falling share price drives up the yield in inverse proportion. so do not make the mistake of assuming that the yeild figures are always sustainable in the future, particularly those that appear astronomically high in relation to the rest of the market.

Also read:
Reading a Cash-flow Statement
Reading a Profit and Loss Account
Reading a Balance Sheet
Reading an Annual Report
Yield and price/earnings ratio (P/E)

5 Value Traps to Avoid Right Now

5 Value Traps to Avoid Right Now
By Joe Magyer
April 24, 2009 Comments (14)

History’s greatest investor, Warren Buffett, has two simple rules.

Rule #1: Never lose money.
Rule #2: Never forget rule #1.


A big, sarcastic thank-you, Warren!

Sure, practically everyone has lost money in this market -- including Buffett. But take it easy on the Oracle here, because he’s dead-on. Buffett’s intense focus on not just investing in great opportunities but avoiding terrible ones has been the key to epic success.

Avoiding soul-sucking investments -- what we investing nerds dub “value traps” -- is hardly rocket science. Yet, incredibly, I see investors new and salty alike make the same mistakes over and over again, breaking Buffett’s rules and walking right into what seem like obvious value traps.

Having spent way too much time thinking about it, I’ve concluded that there are five primary categories of these dreaded mistakes. Avoiding these five traps will save you time, money, and more than a little heartache.

1. The quarter-life crisis
These are a real heartbreaker. You find a dominant company whose once sky-high growth has stalled, and its shares along with it. “TechWidget Corp. is trading at only 15 times earnings right now, only half its five-year average!” you say. “Its earnings have doubled over the past five years, but the shares are down over the same time period. Sounds like a steal!”

Snap! You just walked into a value trap.

Investors falsely believe that names like Dell or eBay (Nasdaq: EBAY) will see their relative valuations return to their headier days. They won’t.

Why? Captain Obvious would say that growth has slowed, technology evolved, and competition emerged. But all that misses the real reason. Instead of returning incremental profits to shareholders via dividends, such companies wreck shareholder value by chasing growth through overexpansion and high-profile acquisitions. Oh, and the ill-timed share repurchases that exist primarily to juice per-share earnings and help sop up all that stock option-driven dilution.

Steer clear of flailing tech titans until they’re willing to follow the lead of Microsoft (Nasdaq: MSFT) and Oracle (Nasdaq: ORCL) into dividend-paying adulthood.

2. The soaring cyclical
Here’s the rub about cyclical stocks: Their valuations are counterintuitive. They always look the cheapest when they’ve reached their priciest, and look priciest when they’re reached their cheapest.

Take nearly any oilfield service stock from last summer as an example. Transocean (NYSE: RIG) looked dirt cheap via a crude, PEG-style valuation. But savvy investors know that cyclical companies’ profits mean-revert, which is why cyclical stocks’ P/E multiples stay low during booms and high during busts.

In other words, you should be looking at cyclical stocks as their P/Es expand, not shrink.

3. The small-cap Methuselah
The six-year small-cap bull run that came crashing to a halt last year was a painful reminder of a little-known value trap: the Small-Cap Methuselah.

Century-old small-caps you’d never heard of were wrapping up five-year runs of 20% annualized earnings growth. Analysts went gaga, extrapolating those growth rates forward like the party would never end. Valuations followed suit. Gaga analyst, meet mean-reversion.

You won’t find long-run compounding machines within the small-cap space. Show me a company with a long, proven history of creating serious shareholder value, and I’ll show you a mid- or large-cap stock.

4. The too-high yielder
A company usually has a high yield (think above 7%) for one of three reasons:

• It has limited growth potential, so managers return as much cash as they can to shareholders (think regional telecoms).
  


• The company is in a clear state of decline and investors expect a dividend cut (think newspapers).
  


• The company is in a tax-advantaged structure that doesn’t allow it to retain much capital (think REITs, MLPs, or BDCs).

Broadly speaking, a high payout is a good thing. There’s a fine line, though. At Motley Fool Income Investor, we’re looking for that sweet spot where an attractive payout meets rest-easy status.

Take my most recent recommendation, Procter & Gamble (NYSE: PG). The stock’s yield of 3.5% is near a multi-decade high despite the company’s underlying earnings power remaining unchanged, if not improving. That’s low-hanging fruit for the income-loving investor.

5. The unopened book
I can already see the Ben Graham fanatics gearing up to peg me with tomatoes, but hear me out. Book values need to be adjusted -- especially heading into and during recessions.

Acquisition-happy companies inevitably end up slashing the goodwill they’d booked while making bloated acquisitions in the years previous. The book values of asset-centric plays (homebuilders, natural resource producers, etc.) also need a good tweaking to reflect the depressed values of those assets. And financials, well, what can I say? Just ask any Citigroup (NYSE: C) or AIG (NYSE: AIG) investor about the ease of assessing their balance sheets.

Don’t get me wrong: I’m all for buying stocks on the cheap. We do just that at Income Investor. But there’s a catch: We’re only interested in good values if they also happen to be great businesses, companies with years of exceptional performance behind and ahead of them. And, of course, ones that pay us to wait for our thesis to play out.

But I digress.

Wrapping the traps
To recap, you can smooth and improve your returns if you:

1. Avoid the stalled-out growth stock undergoing a quarter-life crisis.
   


2. Steer clear of hot small-caps with blah track records.
   


3. Don’t get tripped up by seemingly cheap soaring cyclicals.
   


4. Think twice about the yield that looks too good to be true.
   


5. Don’t lean on inflated or unadjusted book values.
   

You’ve probably picked up on an underlying theme here: You need unconventionally conventional thinking if you want low-stress success in the stock market.

Looking for great, simple-to-understand businesses at good prices is the easiest way to avoid stepping into a value trap -- and bag great returns besides. That’s what I do alongside advisor James Early over at Income Investor, and more than 85% of our active picks are beating the market.

Senior analyst Joe Magyer owns no companies mentioned in this article, though he’s planning to nab a few. Microsoft, Dell, and eBay are Motley Fool Inside Value recommendations. eBay is also a Stock Advisor recommendation. Procter & Gamble is an Income Investor recommendation. The Motley Fool owns shares of Procter & Gamble. The Motley Fool has a disclosure policy.

Read/Post Comments (14) Recommend This Article (113)

http://www.fool.com/investing/dividends-income/2009/04/24/5-value-traps-to-avoid-right-now.aspx

Which shares for income?

Which shares for income?

The yield on BT of 19pc sounds good, but remember the adage "if it looks too good to be true, it probably is.

By Gavin Oldham
Last Updated: 6:47PM BST 10 Apr 2009

With the equity market close to a six-year low and with equity yields at historically high levels compared with gilts, the temptation is there for investors to switch into shares: not only in the hunt for income but also factoring in that one day the equity market will recover.

The challenge is, however, to find those rewards without shouldering too much risk; because whereas cash savings can face risk of default, it is in equities that you face investment risk.

Related Articles
Other inflation hedges
Is silver the new gold?
US fund manager declares war on UK trackers
Inflation: how to protect your portfolio
Deflation: How to protect your portfolio
Investors 'ready to return to stock market'

However, it is also worth remembering that since 1900 high-yielding shares have outperformed the stock market as a whole, 85pc of the time over 10-year periods. They've also outperformed the market since September 2008, when the markets really went into freefall.

As an example of the relationship between risk and yield, let's compare two blue chips with apparent dividend attractions: BP and BT.

This week, the yield on BT is 19pc net of basic-rate tax. Sounds good, but remember the adage "if it looks too good to be true, it probably is". Every analyst in the City expects BT to cut its dividend next time around. Investors should be cautious of above-average share yields: the market is telling you "the higher the yield the higher the risk".

BP has a yield of 9pc. Recently, there has been speculation that the low oil price may force the company to cut the dividend. This has proved unfounded, as BP's management has said the dividend will be maintained this year and it will try to maintain it into 2010, even if the oil price stays at current levels. So here we have some medium-term visibility and potential for capital growth if the oil price rises over the medium term.

When considering an investment for yield, note the dividend cover; this is how many times the profits cover the dividend and is an indicator of whether a company will be able to pay future dividends at the current rate or higher. It is calculated by dividing the net earnings per share by the net dividend per share.

For example, if a company has earnings per share of 5p and it pays out a dividend of 2.5p, the dividend cover will be 5/2.5 = 2. The higher the cover, the better the chance of maintaining the dividend if profits fall. However, a lower figure may be acceptable if the group's profits are relatively stable.

So a good portfolio of equity income shares would feature mainstream companies with good dividend cover and a relatively recession-proof business (such as energy), plus a good helping of the FTSE 100 iShare – a form of exchange traded fund (ETF) marketed by Barclays – to provide some extra diversification, and to provide the opportunity to take advantage of market volatility.

Such a portfolio might include BP, yielding 9pc with 2.6 times dividend cover; GlaxoSmithKline, yielding 5.5pc with 1.6 times cover; National Grid, yielding 6.5pc with 2 times cover; Scottish & Southern, yielding 5.7pc (1.7); Shell, yielding 4.2pc (3.5); Vodafone, yielding 6pc (1.8) plus the FTSE iShare yielding 5.1pc with no cover calculation available.

An investment of £12,000 could therefore give you about £710 income over a full year, an overall yield of 5.9pc.

These equity shares could provide a relatively stable source of income combined with the potential for capital growth. There is, of course, a risk of further setbacks in the markets that could take your investment value lower, but with blue-chip companies like these it's a relatively low-risk portfolio as equities go.

Keep in touch with the companies you've invested in: if you hold the shares in an Isa or a broker's nominee, opt in for shareholder communications direct from the company. It's your right to be kept informed and it shouldn't cost you extra.

Your holding in the FTSE 100 iShare may provide the opportunity to do some tactical purchases or sales. Rather than buying the whole holding at once, you could invest in £1,000 steps as the market falls back, then set a limit at, say, 10pc up on your purchase price to sell as the market strengthens.

This way you can take advantage of short-term volatility to improve the return on the portfolio as a whole. Finally, if you're a taxpayer make sure you use your Isa allowance to minimise your income tax bill.

Gavin Oldham is chief executive of the Share Centre

http://www.telegraph.co.uk/finance/personalfinance/investing/5131421/Which-shares-for-income.html

Investing for income: Dividend yield and Dividend cover ratio

Investing for income: Where savers can escape zero interest rates
As deposit accounts pay next to nothing, dividends on shares seem attractive. But you'll need to choose carefully.

By Richard Evans Last Updated: 3:06PM GMT 06 Feb 2009
The Bank of England's decision to cut interest rates to 1pc means that many savers will now receive virtually no return from their money. As a result, many will be looking for alternative homes for their nest eggs. Among the options are dividend-paying shares.

"Cash-rich individuals will be scouring the stock market in search of a decent income from their savings," according to DigitalLook.com, the private investors' website.

Many large companies pay decent dividends once, twice or even four times a year. The yield – the dividend expressed as a percentage of the share price – is often attractive by comparison with interest rates on savings. There are now a wide range of blue chip companies yielding 4pc or more, DigitalLook said.

When comparing a dividend yield with the interest rate on a savings account, however, certain warnings should be borne in mind.

1. The first point is that your capital is not guaranteed; share prices can and do fall.
2. Secondly, dividends can be cut drastically or axed altogether with little or no notice – and this can lead to a fall in the share price as well.

So just buying the shares with the highest dividend, without researching how safe that dividend is, can be a mistake.
"There are now a huge range of high yielding blue chips but it is best to look for a dividend that is less likely to be cut even if that company's profits fall," said Andy Yates of DigitalLook.

The long-established measure of a dividend's reliability is dividend cover: the ratio of net profits to the size of the dividend payout.

Generally, a cover ratio of at least two – meaning that the company has twice as much net earnings as the amount earmarked for dividend payments – is considered a strong indicator.

A high yield alone is not synonymous with a decent dividend.

Shares in Land Securities yield 9.5pc, for instance, but this reflects investors' concerns about the property market.

There are companies that analysts expect to have a good chance of sustaining their dividends. These include AstraZeneca, the drug maker, International Power and Sage Group, the software firm, according to DigitalLook.

Mr Yates pointed out that an increasing number of companies, including Xstrata, the miner, and JD Wetherspoon, the pubs group, have announced over the past few weeks that they are going to skip their dividends.

But careful research should enable investors to sidestep enough potential problems to build up a well diversified high-income investment portfolio, he added.

"If you carry out thorough research and pick the right shares, you will get better value for your cash than by leaving it in a savings account."

The table below is a selection of FTSE100 companies with a forecast dividend yield of at least 4pc and a dividend cover of two or more.
Source: DigitalLook.com. Based on averaged forecasts from analysts at over 20 investment banks and stockbroking firms as of Feb 5 – forecasts on dividends excludes all UK listed banks
Data as on 05/02/09 at 12.30

Forecast
Forecast

Name
Forecast Dividend Yield...Forecast Dividend Cover

Prudential
5.80% ...4.1

WPP Group
4.20% ...3.4

Next
4.70%...2.8

FirstGroup
7.40% ... 2.6

InterContinental Hotels Group
5.00% ... 2.6

International Power
4.80% ... 2.6

Thomas Cook Group
6.30% ... 2.4

AstraZeneca
5.60% ... 2.4

Rolls-Royce Group
4.60% ... 2.4

Whitbread
4.70% ... 2.3

Smiths Group
4.00% ... 2.2

Aviva
10.60% ...2.1

Reed Elsevier
4.20% ... 2.1

Sage Group
4.10% ... 2.1

TUI Travel
5.30% ... 2

Imperial Tobacco Group
4.20% ... 2

http://www.telegraph.co.uk/finance/personalfinance/investing/shares/4537565/Investing-for-income-Where-savers-can-escape-zero-interest-rates.html