Sharing is Caring and one of my goals is to share my knowledge with the readers of this blog. You guys rock and I get so much knowledge in return again from you 🙏!
Having said that, today I want to briefly share with you a few investor rules of thumb that I often use when analyzing stocks. I truly believe that you should know them.
So let’s get down to business 💪
The Rule of 72
The rule of 72 is a really simple investor rule of thumb that allows you to calculate how many years it takes for your investment to double. See below infographic 👇
Let’s clarify this via two examples:
- You are about to purchase a stock which yields 5% in dividends. You are expecting the dividend to annually grow with an average of 7%. Hence, it would take you ~10 years to get to an yield on cost of 10% when purchasing this stock.
- Currently my dividend income is covering my monthly expenses by approximately 23%. I am assuming an average yearly dividend hike of 6% from all the companies in my portfolio. Hence dividing 72 by 6 means that my dividend income should cover 46% of my expenses in 12 years from now. This assumes that I’m not reinvesting dividends and that my expenses will stay flat over the next 12 years.
- A company has been growing their Free Cash Flow with an average of 10% over the last 5 years. The future looks bright and I think that they can grow their Free Cash Flow with for another 10 years with the same average. This would mean that their Free Cash Flow would double over the next 7.2 years (72/10%). This assumes that the Price to Free Cash Flow multiple doesn’t change over time so the share price should also double in the next 7.2 years.
Simple isn’t it?
I probably use this investor rules of thumb the most when I’m screening new companies for potential adoption into my portfolio.
PS: you can do the same with 114 (triple your money) and 144 (quadruple your money).
The Chowder Rule
The Chowder Rule is a great rule of thumb to do an initial check on the potential total return for a particular dividend stock. It’s a rule created by a person called Chowder who was an active contributor on SeekingAlpha. Unfortunately I can’t find the original article anymore otherwise I would’ve linked it here.
So how does this investor rule of thumb help me?
Well, the rule effectively allows me to check whether a stock is valued at an interesting price (or not) from a total return perspective. It allows me to do this via a quick back-of-a-napkin approach.
The Chowder rule is simple and it consists of 3 variations based on the starting yield or the sector, so let’s get into it:
Dividend Stock with a yield > 3%
5 year compounded annual growth rate (CAGR) + the dividend yield = more than 12%
Dividend Stock with a yield < 3%
5 year CAGR + the dividend yield = more than 15%
Dividend Stock is a Utility
5 year CAGR + the dividend yield = more than 8%.
What I like about this rule is that it also aligns with the idea of getting to 10% Yield on Cost as fast as possible. It includes either high annual dividend hikes or a high starting point with potential lower dividend hikes.
Having said that, the biggest risk with applying this rule is to extrapolate past performance into future performance. There’s no guarantee that the past 5 year compounded annual growth rate (CAGR) will be the same in the upcoming 5 years. Hence you would need to make a common sense guestimate about the upcoming 5 years.
From my experience: the longer you follow DGI stocks, the more familiar you get with them and the more useful this rule becomes.
The value creation rule
This one might be a bit more complex than the first two, apologies for that, but I hope you will understand the value of this rule of thumb.
So let me explain: Ideally we only want to invest in companies that are creating additional value with the money they borrow. But how can you quickly figure this out without going into complex calculations?
Well, just look up the Return on Invested Capital (ROIC) and the Weighted Average Cost of Capital (WACC) for a given company. You will often find these ratio’s online on one of the better platforms (i.e. gurufocus, finbox)
With those two metrics you can apply the following rule of thumb and it tells you whether the company is actually creating value with the money they invest:
ROIC % – WACC % = > 2%
Let me explain this a bit further.
The ROIC is typically used to assess how well a company is investing its capital and turning it into profits. The WACC is actually a bit the opposite. It tells you how expensive it is for a company to invest a Euro.
Hence, you want the ROIC to be greater than the WACC!
Let’s explain this with an example:
Let’s assume that Company A returns a profit of 12% on every Euro invested. The WACC is typically a blended percentage based on the cost of debt (i.e. 5%) and the cost of equity (i.e. 10%). Hence, let’s assume that the WACC is 8%.
In this case the company is creating shareholder value, because the ROIC is 4% more than the cost of capital (WACC)
You can also compare this to your own personal finance. Imagine that you go to the bank to take out a loan with 5% interest payments for half of the required money and you sell some positions in your portfolio that were making 10% a year for the other half of the required money. In such case you could have a personal WACC of 7.5%
Assume now that you would start to invest that money which costs you 7.5% per year. In that case you better find an investment which at least returns you 7.5% as well, but rather even more (+2% more). Otherwise you would just be losing money and the 2% is there as an inflation correction and margin of safety.
Hence why ROIC > WACC is such an important rule to also consider when analyzing stocks. It simply tells you if a company is adding shareholder value with its capital allocation.
As I said before, sharing is caring!
I hope that you find these 3 investor rules of thumb useful when making your own investment decisions. It might just give you that little additional common sense when you get stuck in your stock analysis (and we’ve all been there!).
Having said that, let me know what you think. I’m also very curious to hear the investor rules of thumb that you apply. Feel free to add them in the comment section. I might learn something in return 🙏
European Dividend Growth Investor
PS: I didn’t know if it’s called a rule of thumb or a mnemonic, hence I wanted to share this funny fact with you 👇
If you are a Dutch speaker like me, then you would need to go to Google Translate to check out the term Mnemonic. Let me save you some time and already provide some of the translations:
OK, what the fuck have our Dutch ancestors been smoking?
Ezelsbruggetje literally means “Little Donkey Bridge”.