Doing Your Homework: Rule of thumb

Basic Financial Metrics

Sales per share
Rule of thumb: The higher the better.


Dividends per share
Rule of thumb: The higher the better.


Cash Flow per share
Rule of thumb: The higher the better.


Yield
Rule of thumb:  The higher the better.

Quick Ratio:
Rule of thumb:  Greater than 1 and the higher the quick ratio the better.  If the ratio is less than 1, you would want to assure yourself that the company is generating enough cash flow from operations to cover both its normal expenses and any short-term debt obligations that come due.

Valuation Ratios

Price-to-Sales ratio: 
Rule of thumb:  ratios less than 2 indicate good value

Price to Earnings ratio (P/E):
Rule of thumb:  Historically, stocks are a good value when the ratio or multiple is around 14.  We will consider stocks that have a P/E of less than 20 a decent value based on this ratio - the lower the ratio the better.

Dividend Ratios

Dividend Coverage ratio: 
Rule of thumb:  Minimum of 120%

Dividend Payout ratio:
Rule of thumb:  The higher the better, so long as the ratio does not exceed 100%.   By maintaining a conservative payout ratio of 30%, this allows management to consider increasing dividends as earnings increase.

Growth Ratios

One-year revenue growth rate:
Rule of thumb:  greater than 10% increase in revenue

One-year earnings growth rate:
Rule of thumb:  greater than 10% increase in earnings


Trend Analysis

All preceding ratios
Rule of thumb:  Look for positive trend with an increasing growth in sales, earnings, cash flow, and dividends per share.  The quick, leverage, value and dividend ratios are all positive or well within acceptable ranges.



Caution:  A parting word about a standard rule of thumb
Although convenient, rules of thumb should not be adhered to in isolation. 

For example, electric utilities normally have current liabilities that exceed their current assets, yielding a quick ratio of less than 1.  However, investors are not concerned because utilities have strong cash flow from operations and their accounts receivables are from electricity users who must pay their bills if they want to continue to receive electricity.  If your rule of thumb were rigid, a low quick ratio would be a signal for you to avoid the company and discard promising stocks individually or even across an entire industry.

Ultimately, by integrating these ratios into a single analysis for any given company, you should be able to confidently select dividend-paying stocks that will help you to accomplish your investment goals and to build your wealth slowly over time through compounding dividends and price appreciation.