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CORE GUIDE: Everything you need to know about P/E ratios 2019

The price-to-earnings ratio is the most commonly used, but also the most commonly miss-understood ratio. You look at a stock’s P/E ratio before buying right? The conventional p/e wisdom goes…

The price-to-earnings ratio is the most commonly used, but also the most commonly miss-understood ratio.

You look at a stock’s P/E ratio before buying right?

The conventional p/e wisdom goes something like this.

“Typically anything under 15 is a bargain and anything in the 20s is just way overvalued”

But following such ‘wisdom’ will leave your portfolio lagging.

I have experienced this first hand.

Unfortunately, many new investors and even some experienced ones, are probably looking at P/E ratios the wrong way.

Now, that may come as a shock but by taking a few minutes to read this article you will avoid the most common P/E ratio mistakes and you’ll learn how to properly ‘read’ a P/E ratio.

Priceless information.

This article will focus on four key P/E  ‘themes’ that will help you categorise most stocks just by looking at the P/E.

Here are the themes.

  1. The P/E that tells you nothing (very low or very very high)
  2. Relatively high P/E (20-30)
  3. Very high P/E (50+)
  4. The genuine value P/E

1. The P/E that tells you nothing

I watched a Youtube video a few months back and it made me a tiny bit mad.

It was a video of a guy tipping US Steel stock as a buy.

Nope, nothing wrong with that – but what got me was how he specifically drew attention to the ‘crazy low’ price to earnings ratio.

It annoyed me so bad, I even made a video response (https://www.youtube.com/watch?v=3-AqboHF9fQ).

Not because I don’t like US Steel or even people ‘tipping’ stocks on Youtube.

I responded because it was obvious he didn’t understand P/E ratios and was miss-leading new investors.

Before I learnt about P/E ratios in depth I would have been attracted by this low P/E too!

Hell – I may even have made a video tipping it too!

But, here’s why you should never use P/E alone to value stocks.

It turns out that US Steel is a cyclical stock, even worse, it’s a commodity.

Unless you have some kind of professional insight into the field a commodity is in – and lets face it, most investors don’t have this insight – I’d stay well clear of using P/E as a metric to measure its ‘value’ or investment potential.

So, why is looking at the P/E ratios of cyclical stocks, in my opinion, pointless?

It’ll be easier to explain with an example so let’s take a look at US Steel and take it from there.

US Steel is in the commodity business – Steel.

A symptom of being in the commodity industry means that their business costs depend heavily on the price of ore and their profits depend on the supply and demand for steel.

There is also often excess capacity as there are high barriers to exit from the industry.

Once you build the blast furnaces they’re pretty expensive to close down and then start up again.

Not something I want to be investing in.

But WOW – THAT 6 P/E LOOKS SO CHEAP!

Ermmm, here’s why it’s not.

US Steel’s earnings YO-YO so heavily that the P/E ratio becomes meaningless.

Just take a look at the EPS figures below;

There’s no steady trend of decline or progress here.

Who knows what the earnings for 18/19 will be?

The worst thing is – there’s very little US Steel can do to improve the situation.

They have little control over earnings and thus they are evidently extremely hard to predict.

If anyone can take any useful information for informing a buy/sell decision from this, drop me a comment, I’d love to know!

My main lesson has been to avoid such stocks since I have no expertise in them and they are notoriously hard to value.

My advice? Stay away from such cyclicals.

2. The relatively high p/e

Now and again you’ll come across a company that you really like.

For me these stocks are Visa, Mastercard, Facebook and more.

I spotted Visa years ago but didn’t pull the trigger.

Why? Well….. they seemed expensive.

But I soon learnt that there are ‘expensive’ stocks out there deliver tremendous returns, despite constantly appearing ‘expensive’.

I’ll talk about Visa here – since I now own the stock.

I first looked at Visa back in 2015 at around $65.

The P/E back then at TTM? Well 65/2.16 = 31.56

Wow, to me back then, a so called ‘value’ investor, that was just too expensive.

After all – there’s no guarantee of those future returns will materialise.

Yet here we are, in 2019 and the P/E remains around 30 and the share price has more than doubled.

I bet you’re thinking just what is going on here?

The penny came to drop in early 2018, and I finally bought the stock after reading The Little Book That Builds Wealth & Invest in the best.

Believe it or not some stocks deserve higher valuations and their P/E will simply track their rise in earnings.

But we do have to watch out since there are some stocks at 20/30 P/E that are just plain overvalued.

So how to I weed these out?

I stick by these three rules.

Any stock commanding a high valuation must;

a) Have an economic moat
b) Have very strong margins (Usually hand in hand with a)
c) Have a clear and predictable pathway to increasing EPS

 

Well, to begin with, Visa certainly has an economic moat, being one of only three main players in the payments game and boasting eye-popping operating margins of over 60%!

Earnings history also showed a very smooth upwards march dating back 10 years to 2009 with the only stalling in EPS growth being due to one-off expenses and drops in other operating income, not from core operations that quickly recovered.

The key question that must be asked here is,

Does the quality of these earnings and the security of future growth warrant a 30 P/E?

Only you as an investor can answer that question.

For me?

It’s a yes!

3. The very high p/e

Now we step into scary P/E territory.

I only have one example of a ‘very high p/e’ stock in my portfolio and that’s UK Tonic water maker Fevertree which sports a breathtaking (and not in a good way) P/E of 68.

I think I need to sit down.

I own this!?!

One must be very careful with such companies and my rules for such companies are far stricter.

Here they are;

Any very high P/E company must have;

a) An economic moat
b) Very strong margins
c) Strong history of high double-digit revenue growth.
d)A small market cap
e)High ROCE

As we’ve been over a/b before, let’s focus on points c, d and e.

Why am I focusing on revenue with such high p/e companies?

After all, “Revenue is vanity, profits are sanity”

Well, we would hope with such small companies that money is being ploughed in to expansion and this may hurt the bottom line over the short term.

For example, we may have high selling expenses as products are heavily promoted into new markets.

The only way to try and figure out if the company can maintain this revenue growth is to research into their market (tonics in Fevertree’s case) and to keep a very close eye on progress relative to industry size.

One must also look out for signs of retaliation from existing industry competitors that will drive down margins. (Reading Porter’s Competitive Advantage will help with spotting such moves).

For example, as a Fevertree owner I look very closely at how the company is fairing in the US as this will house most future growth and I also keep an eye on what UK competitor Britvic is doing.

In Fevertree’s case, all currently appears in order with revenue growing nearly 9x in four years.

But – just remember that the bigger a company gets, the harder it’ll get for that revenue figure to grow, hence rule d.

This rule speaks very much for itself.

If you see a company at a £50bn valuation trading at 60 p/e, it’s time to get very skeptical.

That means that the company would have to triple in value to a huge £150bn to mean that you would have paid 20 p/e for your stake in the company at the time it had tripled.

Factor in the time value of money (your money today being worth more than the same sum in 3-5 years) and your purchase must have to perform miracles to have paid off.

But hey, this has sometimes happened!

On the other hand, when we consider that Fevertree has plenty of room left to grow in the US tonic market (if the expansion is successful) then it may not be too ridiculous to envisage the current £3bn valuation growing to £9bn or one of the ‘big dogs’ swooping in to buy this premium brand (Coke, Diageo, Unilever?).

Right, so what about rule e?

What is ROCE and why am I looking for a high ROCE?

The simplest way to explain ROCE is by using a lemonade stand analogy.

Imagine you have a lemonade stand and all is going well.

You decide to invest £100 in order to expand your stand. This £100 could come from equity (share issues and retained earnings) or from taking on debt.

From that £100, you are able to generate £200 in income. 

This means that your ROCE is 200%

200/100 *100 = 200

(Yes I know that this is a VERY simplistic example but it explains the concept well).

For such small companies with the need for us to see our investment grow rapidly in size, then we need to know that the money the company is pumping in to its expansion is really paying off!

Low ROCE would indicate that management is getting desperate and is pumping money into low-quality projects.

This often happens as growth slows and management scrambles for any way to keep investors happy and the share price moving upwards.

As we can see, £1 employed in 2013 would earn the company back £1.05 in 2013

A £1 employed in 207 would earn the company back £1.41

Now – that’s what we like to see.

BUT – we should monitor this trend in case of a sudden drop off due to desperate management and deteriorating conditions for rapid growth.

All that being said, my investment in Fevertree is a huge roll of the dice and I have only invested money that I could face losing 100% of.

Make no mistake, one or two bad earnings reports would see this stock half, or even worse!

4. The genuine value P/E 

Now and again we get to see a stock trading at a low P/E compared to its own 10 year history and the wider market.

Of course, there are often reasons for this and there are seldom bargain basement stocks without an ora of negativity surrounding them.

A consensus wouldn’t make a market now would it.

My favourite examples of the genuine value P/E is Apple, which is currently at a 14 P/E and Next Plc which is currently trading at a 11.7 P/E.

We’ll focus on Next since there’s already plenty of content discussing Apple over at Seeking Alpha.

As recently as 2016 Next was trading at a 15.6 P/E.

As high as 17.3 in 2015.

Today? 11.7.

Now that alone doesn’t make Next a buy.

Maybe there has been some fundamental deterioration in the business.

We must first look into the stock to learn its story.

Doing our research we find out that Next was seen as a FTSE darling, a very cash generative business with a progressing dividend along with generous stock buybacks.

Here’s a company rewarding shareholders.

Taking a glance at Next PLC’s margins gives us an insight into the strength of a company.

I wonder whether this new lower P/E is down to intense competition in the fashion space?

Well, it wouldn’t seem so.

Next has managed, remarkably, to keep tight control on its operating margins.

This may be a sign of some sort of, admittedly narrow, economic moat.

Now adding the headlines of retail gloom together with some investing knowledge it becomes obvious where to look.

While negative industry sentiment is down to some of the drop in valuation, the other reason must surely be the downward trend in revenue (turnover) from 2016 to 2018 and the drop off in operating profit.

Some vertical analysis shows what’s going on here in a much more clear manner than taking the figures at face value.

This analysis shows each line item as a percentage of revenue.

While the first table shows the downward trend of revenue, this second table shows the upward trend in expenses, most notably from 2017 to 2018.

This ‘squeezing’ is evidently putting investors off.

But, for me, this is no problem as every business will experience squeezes every now and again.

Especially in industries such as fashion.

When we balance the cons out with what Next offers, I believe we have a case of ‘genuine value’ here.

Next offers a very safe 3.24% dividend yield and huge cash generation that is being used to buyback shares.

On top of this, despite some big retail companies closing stores, cutting margins and going bankrupt, Next has managed to maintain its operating margins.

Debenhams is down 88% this year, House of Fraser went bust and New Look is closing 85 stores.

Next remains calm and robust, even opening stores.

So, what makes a ‘genuine value’ P/E well, it’s more nuanced than just screaming ‘Value’ at low P/E stocks.

It’s about doing what I did above in order to understand the low P/E and to deem whether it’s reasonable or not.

Conclusion

So there we are.

My P/E rules all laid out.

These rules took me years to develop through hours and hours of reading and many nasty experiences.

If you have enjoyed this article then it would be great if you could share it with friends who may find it useful.

You can also follow me on YouTube here: https://www.youtube.com/channel/UCsevxoeAwjaBmie4TxEAp7Q?view_as=subscriber

Cheers!
Lewys Thomas,
Frugal Student.

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Debenhams going bankrupt? ASOS down 40% – Should I invest in retail?

Who do you think would win in a horse race, me or three time champion jockey Frankie Dettori? Yeah, you’re probably right. Frankie Dettori could probably ride blindfolded and still…

Who do you think would win in a horse race, me or three time champion jockey Frankie Dettori?

Yeah, you’re probably right. Frankie Dettori could probably ride blindfolded and still win.

But what if I was riding a thoroughbred and Dettori a three legged mule?

I think I’d win hands down.

How is this all relevant?

Well, there are many thr

ee legged mules in retail at the moment and few thoroughbreds.

Let’s start with ASOS’s 40% plunge.

Firstly, let me strip away the headlines and the media spin. Debenhams, Next or Topshop would have killed for ASOS’s top-line growth.

If you’d have asked me a few years ago, I too would have applauded these results.

But revenue is vanity and profit is sanity.

ASOS has experienced somewhat of a collapse in so-called ‘EBIT’ margins from 4% to 2% and a 1.6% drop in gross margin. Factor in the tax paid on these earnings and I ponder how much actual cash is left for shareholders.

It really worries me that not so long ago investors were lining up to pay 60 times earnings for this stock. Alas, it’s easy to sit here now the stock has collapsed and to point fingers at others.

Now, I wouldn’t say ASOS is a mule, just a horse with terrible odds.

Call me crazy but I still think ASOS may have further to fall, especially if they don’t fix the margin problem.

Were I a shareholder, I would like to see management abandon the obsession with revenue growth and move to protect operating margins immediately.

With gross margin healthy, it appears business costs are out of control (processing all those returns maybe?)

An all too familiar sight?

Debenhams on the other hand is almost certainly a three legged mule.

Debenhams now boasts negative net margin of -8% in 2018 and a ballooning gap between current liabilities and current assets.

Most worryingly, the business is toast as it stands.

Locked in to constant discounting to try to liquidate stock to cash, customers circle Debenhams like vultures, waiting, knowing that further discounts will come.

Has anyone bought anything at Debenhams for full price over the past year?

Mike Ashley may well be the only man who can save the business.

Is there a future for High-Street retailers?

Absolutely.

Simon Wolfson

Long-term readers will know of my unwavering admiration for Simon Wolfson and his incredible management of Next.

Protecting margins and running the business in a prudent manner.

At the time of writing, Next trades at an earnings yield of 10%.

I have seldom bought a company at such a generous earnings yield and done badly, providing the balance sheet checks out that is.

In short, Next is a good horse with a great jockey. It’s also a horse that I expect to benefit from the decline of wafer-thin margin competitors.

Just take a look at Net Margins;

Looking into my crystal ball, I expect Next to announced it has performed in-line with expectations come the January trading update and investors who sold off the back of ASOS’s share price collapse will feel a bit silly for sharing.

Should this prove untrue, the following decline in the stock price will allow management to buy back shares at bargain basement prices with the hoards of free cash flow the company generates.

Investing in such a financially sound company that’s trading at such low valuations simply because the industry is struggling offers a great risk/reward proposition in my opinion.

Certainly I’m a big fan of next at any price under 5,400p.

For what it’s worth, I also think that JD Sports Fashion looks interesting at these levels but I have not yet had a deep enough look into the company in order to be confident discussing it on here.

Do you own JD or Next?

Let me know what you think by commenting below.

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Stepping away from Dividend Growth Investing

The blog has been quiet and for that I apologise. But, I have finally finished my PGCE course after the most challenging year of my life. I really should write a blog…

The blog has been quiet and for that I apologise.

But, I have finally finished my PGCE course after the most challenging year of my life.

I really should write a blog about the PGCE course sometime - what an experience. It's crazy how some institutions operate.

Anyhow, the GREAT NEWS is that I’m back, and I’m more motivated than ever!

In September I officially start my journey to becoming an investing professional as I study an Msc in Finance and Business Analytics at the lovely Swansea University.

Now, let's get to the meat of the matter and the point of this post.

Some of you may be concerned at the heading of this post ‘A step away from Dividend Growth Investing’. 

After all, I have stuck patiently by Dividend Investing for 4 years now. Noting it as a low-risk, steady investment strategy – but I’ve been convinced to branch out into some higher growth shares.

Here’s why I've branched out.

Over the weeks following the end of my PGCE course I took myself to reading as much as I could about investing.

I went back over the investors bible, The Intelligent Investor, delved deeply into the methods of the godfather of investing, Warren Buffett, by re-reading Warren Buffett and the Interpretation of Financial Statements and taking a close eye to the outstanding archive that CNBC has created covering Buffett in his own words.

Lastly, I challenged myself to read these two classics; Common Stocks and Uncommon Profits by Phillip.A.Fisher and One up on Wall Street by Peter Lynch. Books I had (stupidly) never read before. It was upon reading Common Stocks and Uncommon profits that I began on my journey of change.

                   This book changed my life.

Am I too young to focus solely on Dividend Investing?

It dawned upon me - as a 24 year old student I was investing into companies that have very high capex and operate in industries that were highly saturated, with little room for growth. It's important to note here that I'm not talking about capex used for investing, but capex that's required just for these companies to stand still.

I was putting money into National Grid a company that had absolutely no prospect of compounding my money at anything more than their admittedly generous annual dividend and snail-like 2% earnings growth - see my earlier post on National Grid shares for my previous rationale. National Grid spends millions on maintaining infrastructure but is regulated as to how much it can charge and thus how much profit it can make. 

I also went head first into AT&T, a company that has leveraged itself massively and has decided to compete with other media giants head first through its acquisitions of Time Warner and Direct-TV. I see very little prospect of above-market returns here, even with a hefty 6% dividend. Again, the capex requirements here are huge and the market already saturated.

Now, there's nothing wrong with T and NG - these are solid picks for older investor approaching retirement. The dividends both look safe and will pay handsomely dividends to those who are willing to forgo share price growth.

Let me emphasise, I am not discouraging investments in such companies, I remain absolutely convinced of reliable dividend payouts from the majority of such low-growth companies, even where high levels of capital expenditures are needed.

But, it’s time to admit that I have been blinded by my obsession of ‘value’ in an investment. For so long I held off buying outstanding, high growth companies, such as Visa, Mastercard, Facebook and Nvidia simply because of their high p/e ratios.

In turn, I missed out on the glaring competitive advantages and ability to make above average returns these companies have.

Maybe it was my fault? Maybe I wasn’t valuing these companies appropriately? But, all looked expensive in relation to their 10 year p/e ratios and the market and all went on to raise emphatically in value, bar Facebook as a consequence of its recent, overdone in my opinion, 20% drop.

Here’s a hard learned lesson – an important one to any investor.

Looking at a company’s 10 year p/e ratio to try and determine value can hoodwink you into missing out on outstanding investments.

Surely I can't be alone in having dismissed outstanding companies with outstanding economic moats simply because they looked expensive relative to their 10 year p/e or because they had ratios upwards of 30 even 40.

Sure, it may assist you in painting a background of the company but it has absolutely no bearing on its current value.

It is very possible that a company’s future prospects have transformed dramatically and as a result the company deserves its high valuation.

WHAT?

Yep, this is in complete contrast to my previous approach to investing where I emphasised that one should only value a company on its current fundamentals, exclaiming that these along with the company’s history are the only facts that one can obtain about a company.

The now glaring problem with this stance is that companies change.

A company with an outstanding economic moat and enviable history of earnings growth may be about to face very predictable headwinds. For example, a pharmaceutical company that has just had a patent expire on its star product.

On the other hand, a company with a dreadful or subdued history may have just launched a star new product that will catapult it to a much higher valuation. Just look at Apple pre and post iPhone.

True. It is incredibly risky to try and predict a company’s future. After all, the future is always uncertain. But, one must remember that one can only ever lose 100% of one’s initial investment and that an investment’s upside is theoretically without limit.

So what’s changed?

I’m still a Dividend Growth Investor.

Dividend growth stocks offer enviable protection in economic downturns and instant returns via dividend for investors.

BUT

I am now tilting my portfolio more towards companies with higher growth prospects than my usual ultra conservative investments whilst also retaining many of my previous conservative investments for protection in a downturn.

I have updated my portfolio page to reflect my current portfolio holdings.

Remember to comment below and that I’m always available to answer any questions via lewys@frugalstudent.co.uk.

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Why calculating Dividend Cover is flawed…. What I use instead

Some of my worst investments were made back in 2014/15. That’s the year I really got stuck into investing. I blindly piled into stocks I would never buy at such…

Some of my worst investments were made back in 2014/15.

That’s the year I really got stuck into investing.

I blindly piled into stocks I would never buy at such valuations today.

I look at them in my portfolio today and cringe.

Glaxo Smith Kline, Whitbread… It just hurts.

Now, while Whitbread may be a decent buy at these prices, I’m down 15% and to be completely honest, I wouldn’t be buying at these prices regardless.

Luckily, one core calculation and one change to my investment style has stopped me from getting stung further.

In this weeks article, I’m going to share that calculation with you and that change with you.

Earnings Per Share

Now, many of you would have already heard about EPS (Earnings Per Share). That’s simply a company’s net profit divided by the number of shares outstanding.

This is a key measure often touted by company management, brokers, and analysts.

Naturally, when I first got into investing this was also the key metric I focused in on – after all, that’s what the pros and other dividend bloggers were doing.

Little did I know at this point that this focus would lead disastrous investments.

Now, there’s nothing wrong with focusing in on a company’s earnings per share but it’s the use of EPS in order to determine a dividend’s safety that gets me.

Ever heard of dividend cover?

My focus on dividend cover actually lead to me investing into companies with pressed dividends! 

Dividend Cover

Dividend Cover = Dividend Per Share/Earnings Per Share

For example, Company X has earnings of £1.00 per share and pays a £0.50p dividend then the above calculation results in a dividend cover of two.

1/0.5 = 2

Now, on the face of it, this makes the dividend look well covered.

After all, earnings per share could theoretically half and the dividend could still be paid.

One would assume that the dividend safe right?

Wrong, and I’m going to tell you why.

The calculation for Earnings Per Share is: Total earnings/Outstanding Shares.

So far so good.

Let’s assume Company X has earnings of £100 and 100 shares outstanding (let’s keep things simple).

100/100 = £1 Earnings Per Share.

But, what earnings per share doesn’t take into account is Capital Expenditure – the money a business spends in order to maintain, upgrade and purchase new physical assets.

If Company X spends £40 on maintenance and a further £30 on purchasing a new asset the dividend is suddenly left uncovered by cash generated through by the company’s operation.

We said above that the company paid a 50p dividend per share.

0.50 x 100 (the number of shares) = £50 total dividend paid.

Add on the £70 spend in Capital Expenditure and we can see that the company actually forked out £120 while it only generated £100 in earnings.

Where did that extra £20 come from I hear you ask?

Debt, new share issues or asset sales, all of which are reflected in a company’s cash flow statement and can be damaging over the long term.

Debt and share issues are reflected under the financing tab of a company’s cashflow statement with asset sales  under other investing and cashflow items.

So should you worry if a company has to rely on asset sales, debt or share issues to pay a dividend?

Not necessarily but it means you need to dig deeper into a company’s annual report in order to find out exactly what’s going on in order to determine if adding more debt is sustainable and whether asset sales damage the overall business.

As for share issues – this is almost always bad news for investors!

 

Let’s take a real-world example to see how this all works out

Here’s Whitbread’s Cashflow statement.

We’ll start in 2013.

I always begin by working out a company’s Free cash flow excluding other investing and cashflow items.

This is because I want to see whether a company generates enough cash from its core operations to fund growth and pay the dividend, without the need for any cash generation from Property Plant and Equipment activity such as asset sales.

That’s Total Cash From Operations – Capital Expenditures (Capex).

2013 = £63m

Great, that’s £63m worth of SURPLUS cash that Whitbread has after all costs including Capex.

BUT, we can see that they paid out a £78m dividend meaning that they had to generate £15m.

As it happens, in 2013 WTB gained £50m from an asset sale meaning the dividend is covered (reflected in 2013’s cashflow statement)

Using this formula, we can truly work out whether a dividend is covered.

Do the maths for 2015 and you’ll see that the dividend is grossly un-covered thanks to huge Capex.

Jumping forward to 2017 we can see that the dividend has become even more pressured.

Free cash flow = 626 – 610 = £16m

WOW! The dividend paid in 2017 was a whopping £167m.

Where did the additional £151m come from!?!

Well, if we consider the other investing activities you’ll notice that Whitbread made £200m.

Fair enough right? That covers the dividend.

Well, if we dig into the annual report, we can see that much of this money (186.2m) came from the sale and leaseback of hotels & restaurants.

Thus we have uncovered a red flag!

By leasing back a hotel the company has added an overhead for a one-off payment.

This seems concerning as this sale was required due to the weight of the dividend and the huge levels of CapEx needed in the hotel and restaurant sector.

It’s also worth looking at the company’s liabilities in light of its capital-intensive nature.

                                                                                                          2017          2016         2015         2014         2013

As we can see, total liabilities have rocketed from £1,640m in 2013 to £2,161m in 2017 with total debt nearly doubling.

This isn’t actually that bad considering how cheap debt is at present and considering that the company has also grown its assets substantially.

                                                                                                          2017          2016         2015         2014         2013

We can see that the liability to asset ratio has remained broadly stable (Liabilities/assets)

2013 = 1640/3175 x 100 = 52%

2017 = 2161/4689 x 100 = 46%

But.

Here’s the piece of the balance sheet that makes me cry as an investor.

                                                                                                            2017          2016         2015         2014         2013

Whitbread has issued a further 4m shares since 2013, diluting shareholder equity.

Each time a company issues shares, your stake in the company is decreased.

Someone who owns 1/100 shares in a company owns 1%.

If the company issues another 10 shares, you now own just 0.9%

Whilst 4m shares over 5 years is far from terrible, just 2.2% of total shares outstanding, when we compare this to a company with low Capex and plenty of cash to spare the importance of free cash becomes pronounced.

Here are the number of Next Plc shares outstanding;

                                                                                                           2017          2016         2015         2014         2013

So, how do I REALLY know if a stock’s dividend is under pressure?

Simple.

These are the EXACT steps you need to do.

  • Get the company’s cash flow statement.
  • Do the following equation: Total cash from operations – Capital expenditure.
  • Minus the dividend from this figure.
  • If the remaining figure is larger than the dividend paid then you can consider the dividend safe.

    WORD OF WARNING:
    Sometimes, stocks pay special dividends if they have surplus cash and don’t want to buyback its own shares or invest it. Because these dividends aren’t regularly paid, it’s unwise to include them whilst considering the sustainability if a stock’s ordinary dividend. As such, remember to check if the stock paid a special dividend. If the stock paid a special dividend following the following steps apply.

 

  • Get the company’s cash flow statement.
  • Do the following equation: Total cash from operations – Capital expenditure.
  • Minus the dividend from this figure.
  • Plus the amount paid out as a special dividend.
  • If the remaining figure is larger than the dividend paid then you can consider the dividend safe.

 

Conversely, if there is a need for investing activities in order to cover the dividend payment, you should take a closer look at exactly what’s going on in the company’s Annual Results.

Thanks for reading and I really hope this article has been a help.

If only someone had written this and linked me to it 3-4years ago I’m sure my investments would be in a much better spot.

Once more – I do not make ANY income from this blog. No ads, No affiliate links just me and my laptop.

If you could support my platforms by subscribing to my YouTube channel and sharing this article I would be very grateful.

As always any questions, drop a comment below or E-mail: lewys@frugalstudent.co.uk

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Market Meltdown & A Close Look at BT.

Well well, looks like we’re finally getting a minor correction in the market. The FTSE’s down 1.5% and the S&P500 4.4% About time too! With prices continually creeping higher over…

Well well, looks like we’re finally getting a minor correction in the market.

The FTSE’s down 1.5% and the S&P500 4.4%

About time too!

With prices continually creeping higher over the previous two years with little sign of a correction, bargains are getting harder and harder to find.

Saying that, my recent buys have been in for a rough ride regardless, with;

IMB, CARD, and NG faring particularly badly. Between these, I’m down £300 on a £2500 investment, ouch!

I’m not that bothered though, after all, investing is for the long term and I’m confident these companies will bounce right back and are currently trading at cheap valuations, especially CARD.

My goal is always to increase my yearly income through dividend stocks and not to watch the price of my portfolio rise, although that is somewhat comforting too.

This now sits at over £350!

Regardless, one bit of news this week was the lackluster results announced by BT the previous week.

WOW, am I glad I got out when I did!

With BT now at a 52week low, many people have asked whether now is a good time to get into the stock.

If you’re thinking of taking a punt at BT then keep reading.

BT Overview

Over the past decade, BT has transformed more and more into a ‘media’ company as opposed to its traditional fixed-telecoms base.

This has seen the company step into TV, Sport, Mobile whilst investing heavily in a quad-core offering consisting of;

Landline
Mobile
TV
Broadband

To be fair, BT has been successful in this transformation as the company now looks completely different to how it did just a decade ago. But I remain unconvinced. Here’s why.

Narrow economic moat

Followers of Buffett will be familiar with ‘economic moats’, a term coined by the Oracle of Omaha to describe a company’s continuing and lasting economic advantage.

A wide economic moat denotes a large competitive advantage whilst a narrow economic moat denotes little or no competitive advantage.

Whilst some pundits have argued that BT boasts a medium economic moat with an unrivaled quad-play offering, I think this is unwise.

If we take a look into each of these segments we can see that all are intensely competitive.

Landline

Probably the only area where BT continues to enjoy a competitive advantage. BT owns, operates and maintains the telephone lines under its Openreach division and as such BT can continue to enjoy moderate profits in return for its expertise in the area and continued investment through high levels of Capital Expenditure.

But, with the government seems determined to force a spin-off between BT and Openreach buying the stock purely for this competitive advantage would be unwise.

Mobile

Well, it’s safe to say that EE has no unique offering compared to Three, O2 and Vodafone. Just like airlines, you can offer the best service or best signal in the world but consumers are increasingly focused on price and price alone making charging a premium to increase margins virtually impossible.

TV

Let’s face it. Even traditional TV companies are taking a pounding in the face fierce competition from Netflix and Amazon.

I really think BT made a mistake stepping into this insanely competitive field where they must pay BILLIONS to secure football rights against companies with much deeper pockets (and much smaller pension deficits). Is it really wise to have to add TV rights to a Capex list already containing broadband lines and a black-hole of a pension deficit?

Quick answer: No.

Broadband

Again, fiercely competitive where BT is straddled with the need for huge Capex to upgrade and maintain the lines but are then expected to compete for customers against the likes of Talk Talk, Origin and more.

Another race to the bottom on price!

Capex, Capex, Debt

Whilst BT rightly boasts it £68m increase in capital expenditure in their Q3 results reflecting their ‘ongoing investment in fiber broadband speed and coverage’ the sad fact of the matter is that BT can’t leverage this large investment in infrastructure to any meaningful competitive advantage due to government regulation.

Most worryingly is that BT is loaded with debt.

£21bn to be exact with we include the dizzying black hole of a pension deficit which stands at £14bn.

Taking a look at BT’s Free Cash Flow forecasts we can see that pressure isn’t going to ease up anytime soon.

(1st grid = Q3 17/18 – 2nd grid = FY 17/18 Estimate)

A full year FCF estimate of £863m leaves BT’s £1.4bn+ dividend payments uncovered.

VALUE

Many pundits note that BT is looking undervalued at this point with Morningstar releasing this summary of analyst expectations: http://www.morningstar.co.uk/uk/news/164881/bt-still-undervalued-say-analysts.aspx.

But, with no economic moat, it really isn’t a company that I’d be comfortable having in my portfolio having made the mistake of buying it in my newbie investing days.

FrugalStudent Opinion: Hold with the view to sell at a more reasonable p/e.

 

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OUCH – I caught a falling knife. The dangers of stock market investing.

The stock market. What a crazy place! Anyone who read last Monday’s article would have seen that I recently purchased £222 worth of Dignity Plc shares. Well, these went on…

The stock market.

What a crazy place!

Anyone who read last Monday’s article would have seen that I recently purchased £222 worth of Dignity Plc shares.

Well, these went on to crash and burn 50%.

I must be a genius, right? It takes something special to turn £222 to £111 in just a few days.

Luckily, my portfolio is HEAVILY diversified and the £111 loss I suffered is barely a scratch in my portfolio that’s now approaching £17,000.

Anyone wanting to know exactly what happened to Dignity shares should click here for my live reaction of the 50% drop!

Having just experienced the pain – this seems like the perfect time to talk about falling knives.

The term “catching a falling knife” is when an investor reacts to a declining share price by mistakenly thinking that all the bad news of a stock/sector has been priced in and buying a stock they deemed undervalued expecting a recovery over the longer term.

Last week, I caught a falling knife.

Here’s how I messed up.

Whenever I investigate a company there are two things I generally look at immediately – The market cap and the price to earnings ratio.

These two measurements are related and both hold a clue to how I got burned last week.

Let me show you how.

To illustrate this, let us take a look at two retail competitors, Next Plc and ASOS Plc.

Next currently has a market cap of £7.13B

ASOS, on the other hand, has a market ap of £5.6B

To the newbie investor, it may seem that Next and Asos are of similar scale.

But, if we look at the revenues of both companies we can see that Next is substantially larger.

Next’s 2017 Total Revenue came in at £4,097m with ASOS way behind with Total Revenue of £1,924m.

Here we begin to see how disjointed from reality and business fundementals the stock market can become.

This is why I like to think of the price to earnings ratio of a stock as a indicator of how jointed/disjointed a stock is from the underlying current fundementals of a stock.

Reasonable p/e ratios of 10-18 for the FTSE are my sweet spot. Anything lower may indicate serious underlying problems while anything over may be overvalued.

You see, the key difference between the valuation of Next and ASOS stock comes at their price to earnings ratio.

Next boasts a p/e ratio of a touch over 11 with ASOS trading at close to 89.

That means investors purchasing these stocks today would be paying £11 for every £1 of Next’s earnings and £89 for every £1 of ASOS’s earnings.

But here’s the mistake I made.

The p/e ratio of a stock is based on a stock’s current year’s earnings (ttm – trailing tweleve months).

When I bought Dignity at a 15 p/e I thought I had a bargain!

Here was a solid stock in a recession proff industry trading at historically low valuations.

Sure, competition was heating up but I felt the risk had been priced in to the stock and that it was “worth rolling the dice” regardless of the competition risk.

After all, I was reassured by the words management – they had a statement in November regarding competition and were confident that their pricing stratergy at the time was generally fit for purpose.

BUT – it seems that management really didn’t have a grasp on how much the competiton was heating up, and, in response to falling customer numbers decided to slash their funeral package prices for next year by 25% OUCH!

What? Seriously, in three months things got that much worse?

This folks, is what we call a falling knife.

Just when I thought the bad news was priced in, management dropped a bombshell!

Here, I’ll introduce you to another little phrase – “Value trap”

Let me explain;

Dignity’s 2017 earnings are on track for £1.19 per share and this was the figure used to caluclate the firms p/e raito when I purchased shares, but, next year, after the drastic cuts announced by management Dignity’s earnings per share are forecast to drop to just 88p for 2018/19.

Given these new estimates I purchased Dignity shares at a forward p/e ratio of 21.

21 P/E for a company in an increasingly competitive field?!?!?!

😭 

I got hoodwinked by managements smooth talk for sure and should have stayed well clear until the competition dust had settled.

I can’t say I wasn’t warned and will take everything a company’s management says with a massive grain of salt from now on. I should have stuck to the fundementals and sector trends.

DOH!

What lessons can we take from this investment?

In reality, Dignity’s decline has been a pretty cheap lesson in the grand scheme of things.

Here’s a 50% loser amongst triple digit winners that I invested a lot more money into.

MSFT is up 120% since I bought in, MCD 112%, Apple 91%.

These were all £500 buys.

Luckily, one of my investing rules saved my bacon when it comes to Dignity.

Let me explain – my average investment in a single stock is a strict £500.

If I feel really confident and the stock is meets all my ‘Safe buy’ criteria I’ll go in up to £1,000 as is the case with Unilever and Next. (£800 and £900 respectively)

As Dignity was a small cap stock that had significant risk due to debt and competition, a half position was more sensible.

This is exactly why I arrange my portfolio into a house.

Foundations, Walls, Auxillary.

As Dignity was in my Auxillary it was always going to be a riskier play.

As for Dignity’s future – I’m going to hold and see how things go.

In summary, here are the key lessons I learnt from this investment and my adjustments from here on.

  1. Take EVERYTHING management says with a HUGE grain of salt.
  2. Fundementals and industry trends don’t lie.
  3. I should continue to organise my stocks under the ‘dividend house’ model as this saved me from a material loss.
  4. I should look for companies with wider and more secure economic moats and be wary of a company that’s considering moderate price cuts – this may be a sign of harsher price cuts in the future (as was the case here).

Before going, I have a small favor to ask of you.

At Frugal Student, I hope that you enjoy tracking my portfolio and appreciate the fact that I don’t shy away from any investing mistakes or hide anything from you as a follower.

I’m a full-time student and running this blog isn’t easy.

I don’t earn a penny from this blog and will never run ads on this site – it’s lame and kills the browsing experience.

So, I ask you, if you enjoy my content if you could introduce just one friend to my blog it would mean a lot!

Happy investing.
Lewys

PS: Any questions just drop a comment or E-mail me at – Lewys@frugalstudent.co.uk

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Rolling the dice: Dignity PLC shares.

Hello, and welcome to week 2 of my new year’s resolution to bring consistency to this blog by posting every Monday. Just 50 weeks to go! I’ve been very active…

Hello, and welcome to week 2 of my new year’s resolution to bring consistency to this blog by posting every Monday.

Just 50 weeks to go!

I’ve been very active on the stock market as of late and as such I’m very pleased to present you with my latest buy.

I recently purchased a small position in UK Funeral and Crematoria operator Dignity PLC.

I bought 12 shares of Dignity Plc for a total of £222.00 – meaning one share cost me £18.50 or 1,850p including fees.

Dignity PLC slots nicely into the ‘auxillary’ or ‘roof’ of my dividend growth portfolio – This represents the relatively high risk of this addition.

Links;

1. Business Overview
2. Share History
3. Why I Invested
4. The Dividend
5. The Industry
6. The Risks
7. Valuation
8. Summary

Overview

Dignity PLC is a UK-based funeral operator that operates in three main segments;

1. Funeral Services

2. Crematoria

3. Pre-arranged funeral plans

Funeral services

Funeral services represent 63 percent of the Group’s revenues and relate to the provision of funerals and ancillary items such as memorials and floral tributes. Dignity operates a network of more than 792 funeral locations throughout the UK trading under established local trading names.

Crematoria

Crematoria represent 30 percent of the Group’s revenues and arise from cremation services and the sale of memorials and burial plots at crematoria and cemeteries.

Funeral plans

Pre-arranged funeral plans represent 7 percent of the Group’s revenues. Income represents amounts to cover the costs of marketing and administering the sale of plans. Pre-arranged funeral plans allow people to plan and pay for their funeral in advance.

A brief history of Dignity shares & Why did Dignity shares drop so much?

Since Dignity debuted on the stock market in 2004 it has earned a reputation as a recession-proof cash machine.

The company has easily grown revenue through acquisitions and yearly price hikes of 6-8%.

But what was seen as a recession-proof machine is now somewhat out of favour.

Dignity’s success and high rate of return on capital has enticed competition and as a result, in November, Dignity slumped over 20% to a low of a touch under 1,600p a share after their Chief Executive warned of intense competition in the funeral sector due to an increase in local start-ups.

As most of Dignity’s profit and revenue growth has come from yearly 6-8% price hikes, the market is now spooked that intense competition will strangle margins and lead to slowing or, worse still, declining earnings momentum in the coming years.

There’s no doubt, any need to cut prices and aggressively compete for market share will put significant pressure on the stock.

Regardless of these fears, I swooped in at 1,850p a share.

Dignity’s fall from grace.

So, why did I invest?

Dignity has been on the periphery of my stock radar for a while now but has always been trading at a pretty rich valuation.

But the huge November drop presented me with the opportunity to buy this still growing stock at just 15 times earnings.

Although the funeral care industry is set to become very competitive I am confident Dignity can leverage its scale and its strong cash generation to come out on top when the dust settles and that the current collapse in share price is an over-reaction.

About that cash flow….

One of the main reasons I like Dignity is its ability to generate large amounts of cash.

£58m in 2016 and £73m in 2015.

Such strong cash generation has meant that Dignity has been able to continually expand its operations through purchasing of crematoria (June 2016: 39, June 2017: 45) and acquiring new locations for its Funeral services segment (June 2016: 777, June 2017: 811).

This strong cash flow will enable Dignity to continue acquiring new funeral locations and crematoria to grow its revenue in the short and medium term even if new-entrants succeed in eroding company margins in the short term.

Better than this, such strong cash flow has meant that shareholders have been rewarded handsomely via dividends.

The Dividend

As a dividend investor, a company’s dividend is of utmost importance. This is because a regular dividend helps reduce risk through instant returns and allows me to compound my wealth.

So, what does Dignity’s dividend look like, and is it safe?

Dignity has paid a dividend since 2006 and has increased the dividend by an impressive and inflation smashing 10% a year ever since.

Dignity’s dividend growth.

But is this kind of growth sustainable?

Taking a look at the company’s cash flow for 2016 we can see that the £58m generated in free cash easily covered the £11m paid out in dividends. This results in a FCF payout ratio of just 19%! (11/58 x 100).

As a result of this very low FCF payout ratio – I am very confident that Dignity can continue to grow its dividend at an above-inflation pace for the foreseeable future even if the company faces adversity as a result of competition.

But, a downside to this low payout ratio is that the stock is sitting at a dividend yield of just 1.36%, as a result, investors will need to rely on continued double-digit dividend growth in the far future.

The industry

Funeral services and crematoria are highly specialized industries and one would think that this would provide dignity with a medium, economic moat.

It has spooked investors, therefore, that management is becoming increasingly bearish given the emergence of competition.

I’d even go as far as to say that management took their eye off the ball and took eye-watering price hikes for granted.

But…

As Benjamin Franklin said – ‘In this world, nothing can be said to be certain, except death and taxes.”

thus, the inevitability of death provides Dignity with a somewhat steady flow of business and ensures that the company’s offering isn’t going out of fashion anytime soon!

Better still, the UK’s population is booming and the ONS doesn’t expect that to slow down, projecting continued growth.

It doesn’t look like the services that Dignity offer are going out of fashion anytime soon and such a predicatble and steady flow of business makes Dignity a solid recession-proof play.

The Risks

Having gone so heavily into Card Factory and Next after significant drops in their stock price, readers will be forgiven for wondering why I have invested a mere £222 into these shares.

Well, the answer is that I consider Dignity as a much riskier investment, mostly due to its high debt leverage and the tiny dividend yield.

Dignity’s debt is probably my largest worry.

Dignity is currently holding total debt of £590m with assets standing at just £715m.

This gives a debt to asset ratio of 83% meaning that Dignity is highly leveraged and may find it difficult to access cash if the debt to asset ratio continues to head northwards.

Dignity’s debt pile.

With such strong cash generation, this isn’t a worry, that’s until one considers the direction that Dingity’s management is moving the company.

As competition in the high-margin funeral services sector heats up, Dignity’s management has indicated that it will increase its focus on the acquisition and ramping up of thinner-margin operations in order to fuel revenue growth in future. But – if margins in funeral services get cut significantly due to competition (as management is predicting), the company may become reliant on debt in order to fund these acquisitions.

In the worst case scenario Dignity may face a perfect storm of declining FCF due to tighter margins and the inability to raise revenue through acquisitions due to being highly leveraged although the sheer scale of current cash generation leads me to think that this would be unlikely.

More likely though is that this squeezing of FCF could cause a slowing in the company’s dividend growth leaving me with a low yielding dud!

Valuation

Over the past five years, Dignity has been able to achieve EPS growth (5years) of 9.29%.

BUT – the years of ‘lazy’ growth is over and it’s very unclear as to what EPS growth we could see in the future.

It is therefore VERY difficult to accurately analyze what shares in Dignity are worth today.

If things turn out as I think they will (remember – I have no crystal ball), Dignity will struggle to grow EPS in the short term as competition heats up but will succeed in overcoming the competition and return to higher growth in the medium term.

In order to reflect this scenario, I used the Discounted Cash Flow fair value calculation model to try to put a value on Dignity shares.

I factored in 8 years of EPS growth at 3% and 5% EPS growth thereafter.

This gave me a fair value of 2119p a share.

Summary

Dignity’s management has their work cut out. They can no longer sit back and raise prices by 6-8% a year to smoothly grow earnings.

Increased competition now means they’ll have to work for growth in the future.

The uncertainty in management’s ability to successfully compete and thrive has created a buying opportunity but significant risks remain.

I’m rolling the dice on this one.

Dignity PLC: Speculative auxiliary buy.

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