This is the fifth in a series of articles elaborating on The Dividend Observer Investment Process.
Up to this point, you may have already selected a list of stocks to be purchased. But wait…. Before you press that BUY button, I urge you to activate your RIGHT BRAIN MODE – creative, imaginative and intuitive thinking.
You can use the following questions to verify your emotional health:
- Do you LIKE the business?
- Is it providing acceptable returns?
- Do you think your capital is safe from erosion, even if you have no idea how to compute the intrinsic value of the company?
Now, write down how you are feeling – If not, at least you can freely answer this question: If I have the stock now, how would I feel? How about after a month? After one year? After five years?
Just a few words of caution:
Beware of wanting to just buy and study later
Beware of social media biases
Beware of commitment to buy due to amount of research done
To enhance my confidence and to feel better in the company that I’m going to invest, I include in my analysis the Altman Z-score (measures the company’s likelihood of bankruptcy) and Piotroski Score (determines the strength of the company’s financial position).
Below are the definition of this two metrics taken from Investopedia website.
DEFINITION OF ‘ALTMAN Z-SCORE’
The output of a credit-strength test that gauges a publicly traded manufacturing company’s likelihood of bankruptcy. The Altman Z-score, is based on five financial ratios that can be calculated from data found on a company’s annual report. The Altman Z-score is calculated as follows:
Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings Before Interest & Tax/Total Assets
D = Market Value of Equity/Total Liabilities
E = Sales/Total Assets
A score below 1.8 means the company is probably headed for bankruptcy, while companies with scores above 3.0 are not likely to go bankrupt. The lower/higher the score, the lower/higher the likelihood of bankruptcy.
DEFINITION OF ‘PIOTROSKI SCORE’
A discrete score between 0-9 which reflects nine criteria used to determine the strength of a firm’s financial position. The Piotroski score is used to determine the best value stocks, nine being the best. The score was named after Chicago Accounting Professor, Joseph Piotroski who devised the scale according to specific criteria found in the financial statements. For every criteria (below) that is met the company is given one point, if it is not met, then no points are awarded. The points are then added up to determine the best value stocks.
• Positive return on assets in the current year (1 point).
• Positive operating cash flow in the current year (1 point).
• Higher return on assets (ROA) in the current period compared to the ROA in the previous year (1 point).
• Cash flow from operations are greater than ROA (1 point)
Leverage, Liquidity and Source of Funds
• Lower ratio of long term debt to in the current period compared value in the previous year (1 point).
• Higher current ratio this year compared to the previous year (1 point).
• No new shares were issued in the last year (1 point).
• A higher gross margin compared to the previous year (1 point).
• A higher asset turnover ratio compared to the previous year (1 point).
There you go, I hope you are emotionally stable when you are making a decision where to invest your hard earned money, away from excitement and if required, you can take a break and clear your mind.
In the next article, I will talk about How to build a dividend portfolio, the STEP 6 in the series.
Thank you for reading and all the best in your investing journey!