What are stocks: Which stocks to buy? (Part 5)

If question is which stocks to buy, ones focus must be on stocks which can give high returns in long term

In terms of shareholder’s returns, dividend and EPS are important value indicators.

Dividend is that return for investors which is more like assured-short-term-income.

Long term returns is assured by EPS.

EPS (EPS growth) triggers market price appreciation of stocks in long term.

So when question is, which stocks to buy?

The best stocks to buy are then ones that yields decent dividend and also assures decent EPS growth.

Dividend Income

A portion of net profit of company is paid as dividends to shareholders.

Company which pays high dividends but pays it only intermittently is not interesting.

Investors must look at last 5/10 years dividend distribution pattern of a company.

A good dividend paying stock would have paid dividend consistently with a decent growth.

Dividend Growth: It is not an easy decision for companies to pay dividends to shareholders.

Paying dividends means a compromise on companies available cash / liquidity.

Company will certainly not put its liquidity crisis by paying dividends.

Still, if some company is paying dividend consistently mean they are generating enough cash from its operations.

This is a very good value indicator.

That is why, companies which has consistently paid dividends in last 10 years are considered fundamentally very strong.

But there is an exception.

Company which is carrying ‘high debt’ but is still paying high dividends is not reliable.

It is like company taking debt from banks to pay dividends to its shareholders.

No shareholders wants dividend payment like this.

Companies which carries ‘high debt’ to manage its cash flows (expense) are risky/dangerous.

Such companies may not continue to pay dividends in years to come.

So, to ensure if company will continue to pay dividends, it is advisable to check its ‘debt’ levels as well.

Company maintaining ‘High Reserves’ is most likely to pay consistent dividends.

Reserves are companies own funds. Reserves get accumulated over a period of time.

Retained earnings (PAT minus dividends) gets transferred each year from companies profit and loss a/c to balance sheets.

Accumulated ‘retained earnings’ is called ‘reserves’.

As a rule of thumb, if companies reserves is 70% of total expense, it can be considered as good dividend payers.

High Reserve levels ensure liquidity for company.

Capital Appreciation: EPS

Invariably, long term stocks must exhibit high earning per share growth rate.

Company must increase its net profit each year to enable EPS growth.

But there are cases when PAT is increasing but EPS growth is negative.

This can happen when number of shares outstanding in market is increasing. It dilutes EPS growth.

This is the reason why it is not sufficient to study only Profit (PAT).

Earning Per Share Growth:

There is age old theory that says PE ratio > 15 means stocks price is overvalued.

Peter Lynch tossed the theory of PEG ratio as an exception to PE ratio.

PEG ratio says that if EPS growth rate is robust, even high PE (above 15) can be treated as a good buy.

PEG < 1 is a reliable indicator which says that EPS will continue to grow in future.

If EPS grows, its market price will follow.

Another parameter that ensures EPS growth is ‘appreciating sales turnover’.

If sales turnover of company is increasing, net profit will also improve.

Apart from sales turnover, improving ‘operating margin’ will also profits.

If profitability (margin) of company is increasing, it means it is enjoying ‘competitive moat’.

Companies with ‘moat’ keeps improving their operating margin.

Improving sales turnover and operating margin immediately translates into EPS growth.

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