Dividend Stocks and the Dividend Deep Dive
I started Dividends Diversify to bring structure to my investment process in stocks. To do this, I run my current holdings and potential stock purchases through what I call the Dividend Deep Dive. Let’s learn about it.
What kind of stocks are we talking about? Dividend stocks! As you might know, these companies have some similar characteristics. Specifically, they:
- pay out a substantial share of their earnings in the form of dividends
- periodically increase that dividend payment
- usually have a more mature business and business model
- provide essential services and products
- successfully adapt as consumers and markets change
Furthermore, one of my favorite dividend stocks that has many of these characteristics is Realty Income. They even refer to themselves as “The Monthly Dividend Company”. And monthly passive income is a wonderful thing!
With these company traits in mind, let’s take a look at some of the key metrics I review when performing a dividend deep dive on a company and its stock. Doing your research is a core investing principle.
DIVIDEND STOCKS & COMPANY BACKGROUND
The first step is to understand what the company does. A few of the questions I ask are:
- How do they make money?
- What products and services do they sell?
- What markets do they operate in?
- How long have they been in business?
DIVIDEND YIELD %
The company must pay a dividend. And, the size of that dividend matters. The annual amount of dividends paid divided by the stock price equals the dividend yield. I prefer dividend yields in the 2-5% range. Yet, I do make exceptions and own both higher and lower yielding dividend stocks.
DIVIDEND PAYOUT RATIO
To pay dividends, a company needs income and cash flow. I calculate the dividend payout ratio for the past 7 years. The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
A lower ratio is better. It means a company has a either a greater ability to increase the dividend in future years. Or, if they suffer an earnings decline, the dividend is more likely to be sustained until earnings recover.
I do not have a strict rule on how low the dividend payout ratio should be. I mainly like to understand the trend and how the ratio relates to the stability of the company’s business.
For example, a regulated utility company like Dominion Energy may have a dividend pay out ratio above 80%. Due to the stable and predictable nature of their business, this high level does not concern me.
On the other hand, a company more sensitive to the economic business cycles like Cummins is best having a ratio below 50%. A low ratio is necessary to ride out the potential volatility in their earnings, without needing to reduce the dividend.
DIVIDEND GROWTH %
Next, I look at the trend in dividend growth. I calculate how fast the dividend has grown over the past 1, 3, 5 and 7 year periods.
I also check for how many consecutive years the company has increased the dividend. Some companies have annual dividend increases dating back more than 25 years. These companies are referred to as dividend aristocrats.
After that, I look through management’s information on the investor resources area of their website. I scan for their stated intentions for future dividend increases. Some companies will have clearly stated dividend growth objectives. Other companies will not.
Here is a summary of the information obtained so far:
- Company background and how they make money
- Dividend payout ratio
- Historical dividend growth rate
- Consecutive years of dividend growth
- Management’s future dividend growth objectives
From this information, I estimate how much the dividend will grow on an annual basis in the future.
DIVIDEND YIELD % PLUS DIVIDEND GROWTH %
I like the sum of the dividend yield percentage plus the projected annual dividend growth percentage to be at least 8%. In fact, 10% or higher is ideal.
I won’t bore you with the finance theory. However, finance models suggest the sum of of these two percentages to be your expected future return on investment. Like this:
- + Dividend yield %
- + Projected Dividend Growth %
- = Expected Future Return on Investment %
That’s why I like the sum of these parts to be at least 8%.
Most companies I analyze have one or more significant business risks they are trying to overcome or avoid. For example:
- IBM is struggling to transition from old tech to new tech products and services
- Southern Company is suffering cost over runs from constructing two nuclear power plants
- Apple must continually reinvent its products and services before they become technologically obsolete
I can’t foresee the future, but I try to make a personal judgement on the company’s ability to adapt. I ask myself:
- What is their track record?
- Have they overcome significant business risks in the past?
Or, are they incapable of adapting? Will their challenges put future dividend payments and dividend growth at risk?
These are tough and subjective assessments. But, I do my best to factor them into my decision to buy, sell or hold a stock. If it were easy, everyone would be a dividend stock millionaire.
Finally, I assess the value of the current stock price by looking at these two metrics:
- Price to earnings ratio
- Fair value using the Gordon Growth model
PRICE TO EARNING RATIO
The company’s stock price per share divided by their earnings per share gives us the price to earnings ratio.
I prefer a price to earnings ratio below 20. This is not always possible especially after a multi year bull market run like we have recently experienced. In addition, high quality dividend growth stocks typically carry a premium valuation resulting in a higher price to earnings ratio.
Rather than set a strict limit, I look at the trend. Is the price to earnings ratio consistent with past years or is it significantly higher or lower.
If it is higher, can the company grow earnings fast enough in the future to justify the valuation? If it is lower, why?
GORDON GROWTH MODEL
Finally, I use the Gordon Growth Model to calculate a fair value for the company’s stock price and compare it to the current market price. The model considers several of the factors I have discussed thus far. Specifically,
- Current dividend payment
- Projected dividend growth
- My desired annual return on investment
Using the Gordon Growth Model valuation as a guide. And, after factoring in everything I have learned from the analysis, I determine the maximum price I will pay for a share of the company’s stock.
Buy, Sell or Hold? That’s a summary of how I form my decision.
How do you go about analyzing and selecting your investments?
And, here are a few recent dividend deep dives to check out….
- Compass Minerals
- Dominion Energy
- General Electric
- Hormel Foods
- Johnson & Johnson
- Philip Morris
- Realty Income
- Southern Company
- Wisconsin Energy
Disclosure and disclaimer