The objective of my income portfolio is to make investments that result in continuously increasing cash flow. My expectation is that the capital allocated to this portfolio will not be required for a long period of time (i.e. 15 years or more). This allows me to make investments in individual stocks and take higher risk relative to the market. The process and parameters that I use in my evaluation are as follows:

Trend Analysis

The whole reason for any business to exist is to generate sales revenue and make more profits. At a minimum, the parameters listed below should have continuously increasing trends for past 10 years.

• Revenue
• Earnings per share
• Net cash flow from operations
• Profit/Loss from operations
• Reported net profit
• Gross margins
• Operating margins

Dividend Cash Flow vs. Risk Free Savings Cash Flow

• Why should I take risk if I can get a similar or more cash flow by putting my capital into any risk free savings, fixed deposits, or any such risk free accounts?
• Therefore, here I evaluate if dividend cash flow will exceed the risk free cash flow returns after 10 years of time period.

Quality of Dividends

This section measure the dividend growth rate, duration of growth, consistency over a period of past ten years.

• Dividend per share
• Payout factor: This is ratio of Dividends per share dividend by EPS. Ideally this should be less than 50%. This allows company to retain 50% of the earnings for further capital investments.
• Dividend growth rate: I would like to see a consistently growing dividend percentage or at least a stable percentage. High variability in yearly dividends is perhaps a negative sign in company’s performance.
• Ratio of “net cash flow from operations” to “reported net profit”: This should be more than one. It indicates that companies products and services are provide sufficient cash on continued basis. If it is less than one than, the question is where is company getting additional funds for show profitability?
• Ratio of “operating profits” to “reported net profit”: This ratio should be more than one. For a healthy company, how can the operating profits is be less than net profit?

Beta-based expected return

• Beta is a measure of any individual stock’s risk (or price movement) relative to the overall stock market risk (or index movement). Beta can be measured relative BSE Sensex or S&P CNX NIFTY. I prefer to measure Beta for individual stocks with respect to S&P CNX NIFTY index. We can extend this relative measure to monthly returns (instead of price movements). If we compare the monthly return of individual stock to monthly return of S&P500 index, then it helps us put an expectation on our returns.
• In my stock evaluation, I try to understand how a stock price behaves relative to the market.

Qualitative Analysis

I make qualitative judgment of a given stock based on management’s action, roadmap, business environment, position in market, etc. This is a subjective observation.

Fair Value Calculation

Based on analysis, if I company looks attractive and has sustainable business model, then I estimate the fair value. I estimate the price I should pay to buy a given stock. The different factors that I use for this estimation are:

• Net present value (NPV) price based on 15 year Discounted Cash Flow (DCF)
• Average high yield price calculated based on past 10 years
• Pricing relative to 10 year average price-to-earrings ratio.
• Pricing based on price-to-earnings ratio of 12
• Graham number

Next week I will present analysis for two companies. So stay tuned !!