After reviewing a stock’s dividend and performance history, it’s time to dig in to the fundamentals of the business. The “Annual Fundamentals” section displays 10 charts of key fundamental data to help you quickly review a stock’s business trends.
Sales Growth: displays the percentage change in a company’s total sales from one fiscal year to the next. Growing sales generally support rising earnings, which help long-term dividend growth prospects. KO’s total sales declined 2% in fiscal year 2014 (“FY 14”), and you can see the business held up well during the recession with sales falling just 3% in FY 09.
Diluted Earnings per Share Growth: displays a company’s change in diluted earnings per share from one fiscal year to the next. Earnings growth fuels long-term dividend growth. KO’s diluted earnings per share declined 16% in fiscal year 2014 (“FY 14”).
Diluted Earnings per Share: a stock’s net income divided by the weighted average of common stock shares outstanding over the past year, adjusted for dilutive shares. You want to find companies that have stable to increasing earnings because rising earnings fuel dividend growth.
Free Cash Flow per Share: a stock’s free cash flow divided by the weighted average of common stock shares outstanding over the past year, adjusted for dilutive shares. Free cash flow represents the cash that a company generates after paying to maintain or grow its asset base. Free cash flow is important because it is needed to allow a company to continue paying a dividend, amongst other uses. Look for businesses that consistently generate cash.
Return on Equity: measures how profitable a company is by dividing how much profit a company generated in one year by the amount of money shareholders have invested in the company (net income divided by shareholders’ equity). Warren Buffett believes that return on equity is one of the most important factors in making successful stock investments and tends to favor companies that have earned returns in the mid-teens over long periods of time. Note that companies with high levels of debt will often have a much higher return on equity, so it’s important to also look at a company’s return on invested capital.
Return on Invested Capital: return on invested capital is similar to return on equity, but it differs in that it considers the money equity and debt holders have given the company. It divides a company’s earnings by the sum of its shareholders’ equity and book debt each year. Once again, a good business generally earns returns in the mid-teens and demonstrates reasonable stability.
Operating Margin: this is a measure of profitability and represents the money left after a company deducts its cost of goods sold and operating expenses. The remaining profit is divided by sales to produce the operating margin. You should look at the level, trend, and volatility of margins to better understand a company’s quality level and cyclicality. As of September 2015, the median operating margin across the 2,700+ dividend stocks in our database was 13%, and the top quartile operating margin was 24%. Higher operating margins can be a sign of a higher quality business.
Asset Turnover: this takes a company’s total sales and divides by the company’s total assets (e.g. property, equipment, inventory etc.) that were used to generate the sales. The more sales a company can generate from its existing assets, the better. Improving asset turnover generally leads to higher returns on invested capital. Even if operating margins are low, a company can earn a reasonable return on capital if its asset turnover is very high – think of a distributor or a grocery store as examples.
Long-term Debt to Capital: a leverage metric that measures the proportion of a company’s capital structure that is funded by long-term debt rather than equity. In FY 14, KO’s long-term debt to capital ratio was 0.38, meaning that 38% of KO’s total capital was in the form of long-term debt. More volatile businesses are generally better off maintaining lower levels of debt. For these companies, some caution is warranted if the debt to capital level exceeds 50%.
Diluted Shares Outstanding: as shareholders, our equity stake in the company increases when the business buys back its own stock and decreases when the company issues more stock. Warren Buffett likes businesses that repurchase shares (when they are cheap), and you can see if a stock has been buying back shares or diluting its shareholders by analyzing the trend in this chart. A decreasing slope means that shares outstanding are declining. You can see that KO’s shares outstanding have decreased from 4,786 million in FY 05 to 4,450 million in FY 14.