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Understandably, it’s difficult to assess today whether decisions taken by the CEO will prove successful or not in the future. How do you know that the takeover bid for its closest rival or the move into Asia will be beneficial for the company long term? Some CEOs become media darlings and can do no wrong with journalists during their tenure only to be harshly criticised in hindsight when their plans fail to deliver. This certainly doesn’t help you in coming up with your own opinion.
A good sign is when directors and CEOs hold fairly hefty personal stakes in the company. If a CEO’s cash is on the line, at least his/her motives are in line with those of shareholders.
But not all stocks are suitable for all investors. As we touched on earlier, retirees typically seek stocks paying fat dividends and younger investors target stocks that have the potential to race up share price charts. Since high dividend-paying stocks are generally more established companies operating within more entrenched industries, you might have to forego share price gains for dividend yields.
The dividend yield (not the dividend) is the most important figure for the income investor. So rather than hunting for a stock that pays a $4 per share annual dividend, instead look to the dividend yield, which is the annual dividend per share (say $4) divided by the share price (let’s say $100), or 4%. If you invest $100,000 in a stock offering a 4 per cent dividend yield, you will pocket $4,000 a year in income, not to mention any franking credits to further boost gains.
A word of warning for income investors hunting for the perfect high-yielding stock: a company with a struggling share price can sport a high dividend yield (since share price is the denominator in our dividend yield calculation) so always ensure that the company is healthy, with good prospects for future share price gains. There’s no point buying a stock with a high dividend yield for one year that consequently lowers or stops paying dividends in the future, or worse still, has a plummeting share price. It’s always handy to check the company’s history in paying dividends as a guide to how reliable it’ll be in the future.
Another handy ratio is the "dividend cover," which is gained by dividing the total earnings by the total ordinary dividend payout for the year (interim plus final distributions). This yardstick gives a rough indication as to how secure the continuation of the rate of dividend might be.
Will the company’s share price go up?
If you are buying shares for the prospect of collecting a capital gain, you firstly need to work out whether the share price is likely to go up. So how do you do this?
Well, some investors like to buy stocks 'cheaply' and will patiently wait until the share price drops below a certain level before they pounce, buying up its shares. These investors often look to the price earnings ratio (P/E ratio), which is the share price divided by company earnings (either the company’s reported earnings noted on its most recent annual report, or forecasted earnings determined by broking houses).
This rule of thumb sees a company as ‘cheap’ when its P/E is 10 or less and ‘expensive’ when its P/E is 20 or more.
However it must be remembered that a stock sporting a P/E of say 30 may not be ‘expensive’ or over-valued if the company’s earnings increase quickly in the future fuelling further share price gains. Or a stock that’s trading at a P/E of 8 may actually be ‘expensive’ because it’s simply a dud stock. It might be operating in an overly competitive industry, is losing market share and its brand power is weak.
So the tricky bit is to decide whether a low P/E is simply due to an oversight on the part of the market or whether the stock is really a dud stock that’s going nowhere.
No one ever said that share investing was easy. But if you approach your investment like a shareholder should - as the proper owner of a part-stake in the business - then you are more likely to choose your share portfolio wisely and receive higher returns as a result.
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More articles from this edition of CompareShares
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Stocks: Stock of the week - Metallica Minerals
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Fundamentals: Steps to valuing a company - spotlight on mining services
Resident Trader: Book review - Charting for Dummies
Commodities: Bullish outlook for crude oil
CFDs: Top ten CFD stocks
Expert Panel: Advantages of investing in instalment warrants
Property: House repossessions on the rise
Companies: Centro wins refinancing extension
Stocks: Stock to watch - AMP Limited
Toni Case is Australia’s first journalist to specialise on contracts for difference (CFDs). She was a staff writer for Shares, Personal Investor and Asset Magazines, and today is a regular columnist with the Australian Financial Review. She is a qualified financial adviser.
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