In my previous Post “Why Invest in Dividend paying Stocks” I gave a quick overview of why I choose to invest in companies that pay dividends. I am a huge believer that knowledge is power and that is why I believe you should try and understand as much about what you are doing as possible. Starting from the beginning I will try and give you some insight into how I choose companies that deserve my investment. However before I get into the juicy content and show you the steps I take, I feel it is important to do some ground work and actually understand where a dividend comes from.
Looking at the same thing, but seeing something differently
Perception, is always something that amazes me. Take the dress in the image below. I am like 70% of people and I see a white and gold dress. 30% of people however, see a blue and black dress. How can such a large number of people see two completely different things by looking at the same thing.
Perception in the stock market
Well this phenomena is not just constrained to color illusions and can be translated over to the stock market quiet easily. One of my best mates, went on to study some business economics course here in Waterford and went on to have a successful career to date in the banking sector. We talk quite regular on our opinions on certain companies and stocks and debate over which direction the price will go or what companies are good or bad to invest in. When we talk, it is glaring obvious that we view the market in a different way.
For him, it is like a giant casino and he likes to day trade the swings of the market.I joke with him, that bankers in Ireland usually only like to gamble other peoples money but he does trade with relative success. he hasn’t yet become the wolf of wall street or anything but he appears to be making steady progress. For me,I look at the market graphs the same way i would look at an electrical sin wave on an oscilloscope. Sure there is some noise fluctuations but i am only interested in stocks that do not fluctuate much over time. Remember slow and steady can win the race. Although the market is the same, it doesn’t change, for us, our perception is different because we are looking for different things within the same market.
Assess your risk profile
From the outset, you must make a decision. Are you a gambler? Yes we would all like that one big win but are you comfortable with the potential to lose all your money in the process of trying to achieve this win. Or Are you an investor? Sure it will take longer to get a large amount of cash in return but the risk is far lower than a gamblers risk.If you are not sure one way to find out your risk profile, is by taking this test. Answer as honestly as you can to get an accurate result. if you are like me, you will mainly prefer the steady approach but you may have a little urge to be a gambler every once in a while. For this reason, I divide my portfolio up. I risk a small percentage that I am willing to lose in the gambler portfolio and a large percentage goes into my safer stocks for investing.
One question I have asked my mates in the past is: Would you like to become a owner or part owner of a company?
What surprised me was that the most common answer i received was
“I don’t have enough money to buy or own a part of a company”.
This surprised me, as out of most of my mates, I was by far the lowest income earner due to the fact that I left my job to go back to college, but this also gave me a chance to spread my new found knowledge that buying shares in a company, meant becoming a part owner of that company. The beautiful thing about online stock brokers is that now you can buy shares for extremely low fees, which makes it more accessible than ever for low income earners to accumulate shares over time.The current impression,is that you need at least €10,000 plus before you can start investing. My goal is to prove that theory wrong. In some post in the future, I will share my modest portfolio and how I am growing it on a low income but I only invest €200 a month while i am still studying in college. One thing I have learned over time is that you can make all the plans you want and wait for the perfect time to do something, but the reality is that no time will ever be perfect and plans can often change so if you want to do something. Do it now.Even if you are not 100% ready because I guarantee you that you will become more ready faster than if you sit back and wait.
What is a company
A company to me, is a profit making machine. In a simplistic context, A companies profit is calculated by determining how many sales they made minus the cost of those sales. Not really accounting 101, but trust me, that is about as much as you need to understand at this point. Now assuming the company is profitable, the profit can be reinvested at the companies discretion. For example the company could:
- Use the surplus to pay-down outstanding debt quicker (Can make sense)
- They could Acquire a competitor to increase their market share (Think Facebook buying Instagram)
- They could hoard the cash and do nothing. (this does not make sense)
- Or they could pay all of the owners dividends. (Bingo.. We want these companies)
Obviously, we are looking for profitable companies that are most likely going to pay their owners with a cash dividend. Some companies can pay dividends in the form of more company shares.However as the company issues more and more shares, the extra shares dilute the value and in turn your current shares will lose value. I am in the business of making money and not losing money so i always prefer to target companies that pay a cash dividend.
For a company to pay its owners cash, it makes sense that the company itself must have enough cash to transfer to its owners.For this reason, I only focus on cash generation, or more specifically, a cash flow surplus that the company does not need to maintain its competitive position. This will be known as FREE CASH FLOW when you are looking at a companies account. The reason, I chose to look at the cash flow and not the earnings is that earnings can be manipulated by companies who feel the pressure to meet certain targets as explained by investopidia
“One method of manipulation is to change an accounting policy that generates higher earnings in the short term. For example, assume a furniture retailer uses the last-in, first-out (LIFO) method to account for the cost of inventory items sold, which means the newest units purchased are sold first. Since inventory costs typically increase over time, the newer units are more expensive, and this creates a higher cost of sales and a lower profit. If the retailer switches to the first-in, first-out (FIFO) method, the company sells the older, less-expensive units first. FIFO creates a lower cost of sales expense and a higher profit so the company can post higher profits in the short term.
Another form of manipulation is to change company policy so more costs are capitalized rather than expensed immediately. Capitalizing costs as assets delays the recognition of expenses and increases profits in the short term. Assume, for example, company policy dictates that every expense under $1,000 is immediately expensed and costs over $1,000 may be capitalized as assets. If the firm changes the policy and starts to capitalize far more assets, expenses decrease in the short term and profits increase.”
In short it is important to remember that companies can manipulate earnings but they cannot manipulate free cash flow. That pretty much sums up where a dividend comes from. Remember that companies are not legally obliged to pay dividends and are free to reinvest the profits as the directors see fit. That said I will show you the process of choosing companies that are more than likely going to pay dividends and not only are they going to pay, but they are more than likely going to increase their dividends. (of course you will need to do your own research aswell)
For those of you who are less patient, there are of course people out their who will do the work for you for a small fee. Although I whole heartily encourage you learn as much as you can and find the companies yourself, you could use a service like http://www.dividendstocksonline.com/ who will do all the work for you.