This Popular Investing Metric Is Seriously Flawed
There are countless metrics used by investors to try and explain why a certain company may be a good/bad investment, but as is the case with most things, the context in which you apply them is incredibly important.
One of those metrics that often grabs our attention is the current ratio, which you can find by dividing a company’s current assets by its current liabilities. This ratio is intended to help us figure out if a company can cover its short-term debts, which sounds helpful, but it can actually be a flawed metric if you don’t look at it with the right lens — here’s why.
The general rule of thumb is simple: you want to see a ratio greater than 1.0.
If it’s less than 1.0, that’s typically when the alarm bells start sounding off as it suggests that the company might have a difficult time paying its short-term debts. But here’s where it gets interesting, and here’s where we start to see why context is important.
Some of the greatest companies out there have current ratios less than 1.0:
Procter & Gamble (PG): 0.67
Starbucks (SBUX): 0.78
Apple (AAPL): 0.98
Okay, so why do these powerhouse companies have current ratios below 1.0?
It all comes down to their earnings power. These companies all have the ability to generate massive profits, which is like a financial superpower that puts them in a position to easily cover their short-term debts.
Even more, because of their tremendous earnings, these companies can easily get more financing if they were ever in a pinch and needed short-term cash. This is like having one of those black cards that Jay-Z always talks about, and these companies know how to use it wisely.
But here’s where the plot thickens for us dividend investors.
These powerhouse companies pay out dividends to their shareholders, and they often repurchase their own shares. Both of these actions require cash, and so using that cash can bring the current ratio below 1.0 since cash is an asset on a company’s balance sheet.
In a nutshell, many companies with current ratios less than 1.0 can pay dividends, buy back shares, and still navigate their short-term obligations with ease.
The takeaway here is that the current ratio is only one piece of the puzzle and should be taken with a grain of salt since there’s more to the metric than meets the eye. The same applies to every other metric out there in circulation.
Can you spot any other great dividend-paying companies that have current ratios below 1.0? Write to me here and let me know.
And a big thank you to the 10 readers who responded to last week's newsletter. I really enjoyed reading about how you're all evolving as investors and becoming the masters of your dividend domain. Keep up the great work! 🙌
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All My Stocks Are Getting WRECKED! | DIVIDEND PORTFOLIO UPDATE 📊
As you know, this last month has not been kind to the stock market. All three major indices saw substantial declines in October, and my portfolio was no certainly no exception to that.
The great majority of my holdings were in the red, currently leaving me with some of the greatest losses I’ve ever seen, which we’ll be talking all about that in this month’s portfolio update.
CAREFULLY CURATED
📺 People Are Wrong About Dividend Stocks. Here's Why - Dividend investing is looked down upon by many as being a slow, inefficient way to build wealth. "Who cares about getting a dividend when you can just sell your shares and create your own dividend," they might say. These same individuals will also deploy other low-hanging criticisms to justify why their way of investing is better than yours or mine, and why dividend investing is irrelevant. First of all, who cares what they say. Second of all, they may be wrong, and this video explains why.
🎧 Mohnish Pabrai's Recent Q&A Session At The Harvard Business School - Just because you don't go to Harvard doesn't mean you need to miss out on an Ivy League education. This podcast comes from a recent Q&A session that Mohnish Pabrai did at the Harvard Business School, and we get to listen to it for free — what a time to be an investor! In it, he touches on topics ranging from diversification to how he "shamelessly clones" Warren Buffett and Charlie Munger.
📚 A Few Laws of Getting Rich - Measuring wealth is easy. You just count it up. Measuring some of the downsides of wealth is so much harder and more nuanced. They can be so nuanced and hard to measure that many people won’t even believe they exist. This article sheds light on that, and is a collection of subtle downsides that are easy to ignore, and so common you may as well call them the only true laws of getting rich.
SINCE YOU ASKED
"Could you please share with us when was the first time you felt the 'Snowball Effect' in your portfolio?"
- @1levski | YouTube
The first time I noticed the "dividend snowball" in my portfolio was right around the time when my dividend reinvestments reached a level where they could buy complete shares of stock.
Take, for example, my investment in Altria Group (MO). I've now reached a stage where my reinvested dividends can acquire 4.85 shares of the company every year. Given Altria's quarterly dividend payouts, this equates to around 1.2 shares every three months with my reinvested dividends alone.
This milestone felt pretty big to me. Being able to obtain entire shares of stock without reaching into my own pocket is pretty remarkable, and I think it's around this point that your dividend snowball really starts to take off.
I actually have a video talking about this in more detail, which you can watch here.
Have a question? Ask me here to see it featured in an upcoming newsletter.
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