There are essentially 3 strategies for investing in stocks: Dividends, Value and Growth. Every stock you invest in should be in at least one of these categories. In this article, I will explain what they are and how to find stocks in each of these categories.
Dividend investing focuses on buying stocks with high dividend yields, like 3 to 7% (this is the percentage of your investment that the company pays back to you every year). The goal here is to increase your passive income, while the share price is not as important. With this style of investing it makes sense to hold your stocks as long as they still pay high dividends and the outlook for the company is good. This is strategy has a very low risk and the returns are very stable and predictable. Imagine you buy a company with a 5% dividend yield. After 20 years, you will get the money you invested back while still owning the same number of shares. But there are still some things to look out for when buying stocks with high dividend yields.
Is the dividend sustainable for the company?
One thing to consider is the payout ratio. This is the percentage of earnings a company spends to pay out dividends. If it is too high, that means that a company is likely to cut their dividends. It does not make sense for a company to spend more than it earns just to pay dividends to shareholders. Generally, I would consider a payout ratio above 80% to be relatively risky, while a payout ratio below 50% is pretty good.
Is the business model of the company going to work in the future? Look at trends like digitalization, move to sustainable energy sources, individualization and so on. Are the earnings of the company rising every year? Is the company reinvesting in itself and looking for ways to adapt?
In that case, the future of the company and of its dividends is looking good and the company might even increase its dividends over time.
Learn from the past
You can often measure how reliable a company’s dividend payouts are by looking at its past. A company that has been increasing its dividend for many years is likely going to continue doing so. There is even a name for companies with 50 or more consecutive years of dividend increases: “Dividend Kings”.
dividend yield = annual dividends per share / share price
If the dividend remains the same, then the yield gets higher as the share price decreases. So it also pays to get a good deal (also see Value Investing).
Example: T – AT&T Inc.
Let’s look at one company as an example: AT&T.
From this screenshot we can quickly gather the most important information: as I am writing this, AT&T has a dividend yield of 7.14%, which is extremely high. You could also get this number by calculating $2.08 / $27.46. The payout ratio is 59%, which is not too high and this company has been growing their dividends for the last 35 years, which is good for the safety of the dividend. However, the dividend has not been growing much in the last 5 years.
But these are just the numbers, remember to take a close look at the company as well.
- Goal: increase passive income
- Look for: high yield, low payout ratio, rising earnings, “future-prove” business model, good price
- Risk: low
By the way, a good website to check all these things is SeekingAlpha.
The basic idea of value investing is to find companies that are undervalued, which means buying them for less than they are actually worth. Sometimes a company faces a temporary crisis, which gets priced in too much. If you believe that this crisis is really only temporary and that the company can recover, then you may have found a value stock. Probably the best known value investor is Warren Buffett, who said:
Price is what you pay, value is what you get.Warren Buffett
In other words: sometimes the price of a stock is unjustified and below what it should be. Some useful metrics for determining the value of a company are the following:
Price to Earnings (P/E) Ratio
A very important metric for a company is how much it earns. Earnings are what is left over from the revenue after all the expenses are paid. To get the P/E ratio, you just need to divide the share price by the earnings per share (EPS). For example:
Apple closed at $241.41 with an EPS of 12.60. That gives a P/E ratio of 241.41 / 12.6 = 19.16.
If a company has a low P/E ratio, its price is relatively low compared to its earnings, which could mean that it is undervalued. Average P/E ratios in recent years have been around 15 to 20, but it depends on the industry. Financial companies have lower P/E ratios, while tech companies usually have higher P/E ratios. A stock with a low P/E ratio is not necessarily a good investment, though. A low P/E ratio could also mean that the earnings are just really low or even negative. So you still need to be careful to avoid “value traps”.
Price to Book (P/B) Ratio
If you take all the cash and assets of a company and subtract the debt and liabilities, you get the book value. So if you sold all the parts of the company, that’s how much you would get for it. If this ratio is under one, then you literally get more than what you paid for.
Don’t get distracted too much by these metrics, though. They are just tools to find out if you are getting a good deal. You still need to make sure that you are also buying a great company (more on that in my other articles).
Example: CCL – Carnival Cruises
An example for a value stock right now might be Carnival Cruises, by far the biggest cruise ship company in the world. Because of the Coronavirus, the revenue of this company is zero for the next few months. At the same time, it still spends about half a billion dollars every month to keep everything operational. There is a chance that this company will go bankrupt, which is how the stock is priced. Right now CCL is trading at a 0.23 price to book ratio. If it did go bankrupt, you would lose your entire investment. On the other hand, CCL has recently raised enough cash (through bonds and stock offerings) to survive about 12 months without any revenue. The cruise ship business model was very successful in the past and growing at a steady rate. If you believe that CCL can survive this crisis, the price looks extremely attractive. Especially when you consider the potential future dividend once the company is profitable again, which was relatively high even before this crisis.
- Goal: find undervalued stocks
- Look for: great companies that are going through short term trouble, low P/E and P/B ratios
- Risk: medium, if you know what you are doing
These are companies that are growing at a very fast rate (often exponentially). Unlike value stocks, it is not uncommon to see extremely high P/E ratios or even negative earnings in growth stocks.
Growth companies can offer very high returns. With some companies, you could have doubled your money in one year by investing in them at the right time. But they also have the highest risk associated with them. The key is to find an innovative company, with a disruptive approach and great products, which you believe can execute their vision. Valuations don’t matter as much here, but they should not be disregarded entirely.
One metric to measure growth is year-over-year growth in revenue. Above 20 to 30% is pretty high.
Example: TSLA – Tesla
A good example for this would be Tesla. If you believe in Tesla, you might think that it will grow rapidly over the next few years and become a very important and big company which would increase their market capitalisation by multiples. Otherwise, you probably think that $100 billion is too much for a car producer that has been profitable for only a few quarters and sells only about half a million cars per year. Meanwhile competitors like Volkswagen sell 20 times as many cars, are also developing electric cars and are worth only about half as much as Tesla.
- Goal: find fast growing stocks
- Look for: innovative companies, with a disruptive approach and great products, which you believe can execute their vision. High revenue growth.
- Risk: high, unless you are an oracle (not the company though)