Gauging your risk tolerance
Every investor has a different comfort zone. The thrill-seekers crave risk. They want big returns and are willing to take big risks to get them. Riding the rollercoaster of the stock market doesn’t bother them, as long as they have some hope they’ll end up on top. On the other end of the spectrum are conservative investors willing to trade high returns for stability. Prior to investing in anything, you can benefit by determining whether you’re more of a thrill-seeker, a conservative investor, or someone in between.
In Chapter 7, I offer several methods for gauging risk tolerance, but regardless of which method you choose, you should account for the following factors:
✓ Age: Younger investors can generally take bigger risks because they have less money to lose and more time to recover from lousy investment decisions.
✓ Wealth: “Never bet money you can’t afford to lose” is good advice for both gamblers and investors. If you’re relying on the money you’re investing to pay your bills, send Johnny to college, or retire soon, you’re probably better off playing it safe.
✓ Personality: Some people are naturally more risk-tolerant than others. If you tend to get worried sick over money, a low-risk approach is probably more suitable.
✓ Goals: If your goal is to reap big rewards quickly, you may conclude that the risk is worth it. If your goal is to build wealth over a long period of time with less chance of losing your initial investment, a slow, steady approach is probably best.
Choosing the right approach
Tossing a bunch of ticker symbols into a hat and drawing out the names of the companies you want to invest in is no way to pick a dividend stock. Better approaches are available, as presented in the following sections.
Value
The value approach is like shopping at garage sales. Investors hope to spot undervalued stocks – stocks with share prices that appear to be significantly lower than what the company is really worth. When hunting for values in dividend stocks, investors look for the following:
✓ Strong earnings growth: Companies that earn bigger profits with each passing year demonstrate they’re growing and thriving. A shrinking profit usually means trouble – bad management decisions, increasing competition, or other factors chipping away at the company’s success.
✓ High yields: Yield is the ratio of annual dividends per share to the share price. If shares are selling for $50 each and dividends are $2.50 per share (annually), the yield is $2.50/$50.00 = .05 or 5 percent. Stocks with higher yields deliver higher dividends per dollar invested. For example, a dividend stock with a yield of 5 percent generates a nickel for every dollar invested, whereas a yield of 25 percent generates a quarter per dollar.
✓
Low price-to-earnings ratio (P/E): P/E tells you how many dollars you’re paying to receive a share of the company’s profits. If a company earns an annual profit of $3.25 for each share of its common stock and the shares sell for $50, the P/E is $50/$3.25 = 15.39. In other words, you’re paying $15.39 for every dollar of profit the company earns. The P/E ratio provides a barometer by which to compare a company’s relative value to other companies and the market in general. (Head to Chapter 2 for more on common stock.)
✓ Solid history of raising dividend payments: Like strong earnings growth, covered earlier in this list, a solid history of raising dividend payments demonstrates that the company is thriving. Every year it has more wealth to share with investors.
✓ Solid balance sheet: A balance sheet is a net worth statement for a company, listing the cost of everything it owns and subtracting the cost of everything it owes. Ultimately, a healthy balance sheet shows that the company has enough assets to cover its liabilities and then some. The remainder is called shareholder equity. For more about balance sheets, flip to Chapter 9.
✓ Sufficient free cash flow: Ideally, a company’s cash flow statement shows that the company brings in enough actual cash each quarter to more than cover its expenses as well as the dividend distributions.
Growth
The growth approach to investing in the stock market focuses on a company’s prospects for generating future earnings. These companies are expected to see their revenues and profits grow at a pace faster than the rest of the market. As such, this approach tends to be more speculative than the value approach. Growth investors may pay more for shares than their past results or actual performance justifies.
With the growth approach, value isn’t the key variable. Although P/E ratios remain important, growth investors are willing to pay a higher price for shares than value investors. Because growth investors look to share price appreciation for returns, they’re more likely to focus their attention on companies that don’t pay dividends. They want younger companies that reinvest their profits to accelerate the growth rates of future earnings and revenues. If the company continues to exhibit strong growth, the share price should move significantly higher. Growth investors are well advised to consider the following:
✓ Revenue growth: Although earnings (profits) can grow through cost cutting, revenue growth demonstrates the company’s sales are increasing.
✓ Projected growth: Projected growth consists of analysts’ estimates of the percentage the company’s revenues will grow in a year. These projections always carry some uncertainty, but investors should still take them into consideration.
✓ Profit margins: If the company reports a profit, growth investors want to see profits and revenues growing on a steady basis. Profits not keeping pace with growing revenues may be a sign that the company’s profit margin is suffering.
✓ Realistic share price projection: Generally speaking, growth investors consider investing in companies only if they have a realistic expectation that the share price will double no later than five years down the road. The key word here is “realistic.” Investors must base projections on data rather than gut feelings.
Income
The goal of income investing is to obtain a steady and relatively secure income stream. When purchasing equities, focusing on income means buying stocks that pay dividends. Because most growth companies don’t pay dividends, most income investors are basically value investors that not only want
