Attractive Value Ratios Are Neither Necessary Nor Sufficient
Whenever a potential stock investment is mentioned the first question that is often asked is “does it pay a dividend”?
The assumption appears to be that only dividend paying stocks are good investments. If so, someone forgot to tell stocks like Berkshire Hathaway which has been a spectacular investment despite the fact that its last dividend consisted of a lowly and lonely ten cents paid in 1967. Another example is Stantec Inc. which has risen over 2000% from $2.50 in September 1999 to $53.66 today. It rationally did not pay a dividend and only started to pay a dividend in 2012.
Many investors insist on a high dividend yield. Others insist on a low price to earnings (P/B) ratio. Others insist on things like a low debt level, strong cash flow, strong revenue growth, strong earnings growth or a high return on equity.
These are all good qualities to look for in an investment. And they may tend to work on average. But there simply is no valuation ratio of this sort that is either strictly necessary or sufficient, on its own,to qualify a company as a good investment.
For one thing these ratios are calculated at a point in time. At many companies profits can be notoriously volatile. A profit figure that is affected by a large and unusual gain or loss can completely distort ratios such as the P/E ration, the earnings growth, return on equity and return on capital.
The payment of a dividend is no guarantee of a good investment. There have been many cases where companies continued to pay dividends even as earnings evaporated. Obviously, that can only occur for a limited period of time.
In some cases investors are far better off if the company does not pay a dividend. If a company has the opportunity to grow and can invest in highly profitable projects and expansion opportunities then investors may be better off if the money is sued for that investment rather than paid out as dividends.
In theory, every good investment in a stock should be made at a share price that is not greater than the estimated true (or intrinsic) value per share. In theory then a price to intrinsic value ratio must never be grater than 1.0. In practice it is impossible to ever know the intrinsic value. For some companies reasonable and conservative estimates can be made.
In conclusion, investors should be cautious when adopting strict rules about dividends or other value ratios. There simply is no one ratio that is both necessary and sufficient to assure that a given stock is a good investment. Nor can any one ratio conclusively rule out a company as a good investment.
Shawn Allen, CFA, CMA, MBA, P.Eng.
President, InvestorsFriend Inc.