5. Getting Started with Value Dividends

Before you go out and adjust your portfolio with value dividend stocks, I want to lay out a few important concepts for you as a “vale dividend” investor. First, by looking at how to calculate an intrinsic value considering the financial-, business-, macroeconomic- and industry risks. Then at significant risks and trends I see as of the end of 2022.

Unpopular vs. Bad Stocks

In my study, I created quantitative portfolios. This means, as long a certain stock fulfilled certain criteria, they were part of the portfolio.

I didn’t look at each company in detail, which means I didn’t look at the management. I didn’t look at the product offering and I didn’t look any further into the financials of the companies which were part of the portfolio.

To blindly invest in such a stock portfolio would be – by many value investors – considered speculating not investing.

Stock screening is therefore only the first step, which I call the discovery phase. You start with a market of thousands of stocks and filter it down to undervalued stocks which pay (1) a significantly high or (2) no dividend at all. As a result, you will have two portfolios:

  1. One value portfolio which pays a very high dividend,
  2. One value portfolio which pays no dividends.

Stocks which are part of these portfolios will most certainly be unpopular and unsexy stocks. Otherwise, they wouldn’t be undervalued and – in addition – pay a significant dividend or no dividends at all.

This “unpopularity” is not bad in itself. As we’ve seen in the study, these “unpopular” stocks seem to offer the biggest opportunities. But we need to understand what we don’t understand yet:

  1. Why are these stocks unpopular?
    • What makes these stocks unsexy?
  2. Why do these stocks pay such a high dividend?
    • Which risks is the high dividend compensating?
  3. Why do these stocks pay no dividends?
    • Which opportunities do investors currently oversee?

To differentiate between an unpopular and a bad stock, we also want to understand exactly:

  • the business model of the business,
  • the risks and opportunities of the business model,
  • the quality of the management,
  • the financial health of the business, and it’s bankruptcy risk.

As soon we’ve understood the business, we also have to come up with an intrinsic value of the stocks so that we invest only in those with a healthy margin of safety.

Calculating Intrinsic Value

Ultimately, every value investor develops his own way of calculating the intrinsic value of a company. What they all have in common is that they look at and analyze the potential growth outlook, they look at the competitors, a company’s earnings power, and, for example, the ability for continuous dividend payments.

Warren Buffett prefers rather simple metrics which are easily measured. Basically, metrics you do not need a complicated Excel for, such as Return on Equity and the popular “Owner Earnings”, which he popularized.

Other investors focus on other metrics or entire checklists:

  • Michael Price uses merger and acquisitions to find out how much a knowledgeable buyer is willing to pay for a similar business.
  • Glenn Greenberg uses the discounted cash flow analysis.
  • Mario Gabelli uses his own valuation method, which he calls Private Market Value – which is akin to the net-net method of Benjamin Graham1.
  • Vitaliy Katsenelson, author of “Active Value Investing” uses a more sophisticated valuation model which combines multiple metrics.

How you calculate the intrinsic value of a company is ultimately up to you. You have to find an approach which works best for you. But make sure to not skip this step. Only by defining a realistic intrinsic value of a business, you can make sure that you invest only in businesses with a large enough margin of safety.

My personal approach is to look at different unbiased and unfalsifiable metrics of a stock. If you read “adjusted” you have to pay attention. “Adjusted EBIT” can mean anything. It basically says: “adjusted to what we want to be true”.

In the following two chapters you can find metrics and formulas which are useful to separate the wheat from the chaff.

Financial Risk

There are several ratios which can be helpful to assess the financial risk of a stock. It is therefore helpful to look at each of these ratios, before making an investment decision.

  1. Altman Z-Score
  2. Free Cash Flow to Payout Ratio
  3. Net Financial Debt to Total Assets Ratio
  4. Credit Rating

The Altman Z-Score

In statistics, a Z-score – also called standard score – is showing how far a specific data point is from the mean of the data. This makes Z-scores useful when comparing data from different sets of data.

The Altman Z-Score is a financial model invented by Edward Altman which is used to determine a company’s likelihood of bankruptcy by looking at the profitability, leverage, liquidity, solvency, and activity ratios of a business.

The Altman Z-Score looks at different ratios, adds them up, and then compares them to a graded scale.

Today2, a Z-score close to 0 or below 0 means a business is headed for bankruptcy. A Z-score above 3 means the business is financially stable. It is calculated as follows:

Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

With:

  • A = working capital / total assets
  • B = retained earnings / total assets
  • C = earnings before interest and tax / total assets
  • D = market value of equity / total liabilities
  • E = sales / total assets

Most good stock screeners already show you the Altman Z-Score of a stock and allow you to screen the market according to it.

Note: The Altman Z-Score does not work for new companies, which will always end up with a low Altman Z-Score. Furthermore, the Altman Z-Score leaves out the cashflow of a company. A company might have a high Altman Z-Score and still be unable to pay their bills and thus declare bankruptcy.

Free Cash Flow Payout

Usually, companies like to advertise their “dividend payout” which is calculated by dividing the annual dividend per share by the annual earnings per share (EPS).

While this may sound useful in the beginning, the dividend payout comes with two fundamental problems:

  1. Earnings ≠ Cash
  2. Earnings include cash and non-cash earnings as well as operating and non-operating earnings

What the investor really wants to know is how much cash as a percent of earnings is paid out to investors. Thus, we need a more accurate ratio which is based on cash flow rather than accounting earnings.

By focussing on the free cash flow of a company – which represents all the cash which is actually available to repay creditors and pay out dividends – we get a clearer picture of the actual amount returned to investors as well as the company’s ability to maintain or increase the dividend.

The Free Cash Flow Payout Ratio is simply: Annual Dividend Per Share / Free Cash Flow Per Share

Because we are talking about free cash flow and not accounting earnings, a percentage of 70% or less will be fine.

Net Financial Debt to Total Assets Ratio

Comparing the total debt to total assets of a company shows us the degree to which a company used debt to finance its assets.

The higher the ratio, the more leveraged the company is. For example, a ratio of 0.4 indicates that 40% of the assets are financed with debt and 60% financed by shareholders’ equity. A ratio of 0.7 would mean that 70% of the assets are financed with debt. A negative number means the company has more cash than debt.

Overall, businesses with a very low (<0.3) or negative Net Financial Debt to Total Assets Ratio carry less risk of cutting the dividends in the future.

The ratio is calculated as follows:

Short-Term Debt + Long-Term Debt – (Cash + Cash Equivalents)

Credit Rating

Credit ratings are based on substantial due diligence by one or multiple rating agencies whose job is to take a balanced and objective view of the financial situation of a company regarding its ability to pay its debt and interest obligations. The credit rating not only determines if and at what interest rate a company receives a loan, it is also a relevant indicator for investors, as a bad credit rating indicates a higher probability that a company might default on debt, interest, and thus dividend payments.

The rating classification is different depending on the rating agency, but overall an AAA rating is the best, and a C and D the worst ratings.

It doesn’t necessarily mean investors should avoid companies with a bad credit rating in general – but it surely means value investors should demand a significantly higher margin of safety to compensate for this risk.

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Business Risk

The following metrics are one way to discover the business risks of a stock as an outsider.

Gross Profitability Ratio

The Gross Profitability Ratio is calculated as Gross Profit to Total Assets and was introduced by Robert Novy-Marx as a better alternative3 to other strategies such as the Greenblatt magic formula or the Piotroski F-Score.

The Gross Profitability Ratio rests on the fact that numbers such as the Net Income, EBIT, and EBITDA can be manipulated or distorted with accounting. That’s why the Gross Profitability Ratio only uses input from the top of the income statement to find out how much profit the company’s assets are producing.

A high Gross Profitability Ratio is a sign that a company has a sustainable competitive advantage. Otherwise, the competition would simply enter the market and thereby lower the profits.

Gross Profit to Total Assets = (Revenue – Cost of Goods Sold) / Total Assets

Piotroski F-Score

Named after the accounting professor Joseph Piotroski, the Piotroski F-Score has itself since proven as an indicator for a company’s future stock price performance.

The Piotroski F-Score is a score between 0 and 9 and reflects nine different criteria to determine the strength of a company’s financial position. If a company passes one criterion, it gets one point, if it fails one criterion, it gets no point. This makes 9 the best score and 0 the worst score.

It looks at the performance in three different categories:

  1. Profitability
  2. Leverage, liquidity, and source of funds
  3. Operating efficiency

Profitability Criteria:

  1. Positive net income (1 point)
  2. Positive return on assets in the current year (1 point)
  3. Positive operating cash flow in the current year (1 point)
  4. Cash Flow > Net Income (1 point)

Leverage, Liquidity, and Source of Funds Criteria:

  1. Decline in long-term debt, compared to the previous year (1 point)
  2. Higher current ratio than previous year (1 point)
  3. No dilution of shares (number of shares this year < number of shares last year) (1 point)

Operating Efficiency Criteria:

  1. Higher Gross Margin than last year (1 point)
  2. Higher Asset Turnover Ratio than last year (1 point)

Companies with 7, 8, and 9 points provably outperform stocks with a 0 – 4 points.

All in all, the Piotroski F-Score is a great tool to find deteriorating companies (companies with a score <6) and outperforming companies (a score of >6).

Return on Invested Capital (ROIC)

The ROIC is a very popular measure among value investors which shows how well a company is using its capital to generate profits.

When the ROIC of a company is higher than its cost of capital, the company is healthy and growing. However, if the ROIC is lower than the cost of capital, the business model may be nonsustaining, and it’s worth looking in great detail what is causing it.

Macro-Economic and Industry Risks

To avoid large losses, it is absolutely crucial to really understand the macroeconomic and industry-specific risks of a stock.

No matter how good a stock looks at the last annual return, macroeconomic factors can flip a profitable, attractive value stock to a penny stock within days and weeks.

Imagine you find a very attractive stock in Germany. It looks great on paper. Fairly undervalued, a great management, solid cash reserves. But if you look at the macroeconomic situation, you realize that the business is entirely dependent on cheap Russian gas – which unfortunately stopped flowing to Germany. With it, the entire business model of the business becomes obsolete.

As you can see, it is crucial to understand in the macroeconomic environment as well as the industry we are investing in.

In the next chapter, we’ll look at the most important macroeconomics and industry-specific risks as of 2022. If you read this later than 2022 or 2023, you can skip the next chapter. But especially then it is crucial that you try to understand the new macroeconomic and industry-specific risks yourself.

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  1. Greenwald, B. C., Kahn, J., Sonkin, P. D., & Van Biema, M. (2004). Value investing: From Graham to Buffett and Beyond: John Wiley & Sons. 

  2. 50 Years of Altman Z-Score – Public lecture at LSE by Edward Altman; Accessed on August 29, 2022, via: https://www.youtube.com/watch?v=iV6yaDMPMKM 

  3. Roberty Novy-Marx. Quality Investing. Retrieved August 29, 2022, from http://rnm.simon.rochester.edu/research/QDoVI.pdf 


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