I’m a big fan of dividend investing. I took advantage of cheaper stock prices during the last economic recession and stumbled my way into a sizable dividend portfolio.
Now that we’re nearly a decade away from my initial acquisitions and the markets have surged back, I’m sitting on big gains and healthy cash flow.
Today, our annual dividends exceed the annual salary I was paid in my first “real” job. It’s a nice little monthly dividend paycheck.
I had a process of how I picked the companies but I was in a very favorable environment. If you are willing to wait, you will most certainly win.
When Ben Reynolds of Sure Dividend and I got to talking about sharing his wisdom with you all – I knew I needed to know his process.
I’m excited to share this guest post about the numbers he looks at when making a decision about buying a dividend stock.
Take it away Ben!
Table of Contents
The financial world is filled with metrics and numbers of all kinds. The ‘basic’ Google Stock Screener has over 50 metrics to screen stocks. Other screeners have significantly more metrics.
The sheer number of financial numbers available can lead to paralysis-by-analysis. This article shows a way to quickly identify high-quality dividend growth stocks to invest in using only 4 different financial numbers.
Number 1: Dividend History
Dividend history is not a commonly used metric – and that’s unfortunate. Companies with long histories of paying rising dividends every year have historically performed very well.
The Dividend Aristocrats Index is an example of this. To be a Dividend Aristocrat, a stock must have paid increasing dividends for at least 25 consecutive years and be a member of the S&P 500. There are currently only 53 Dividend Aristocrats as of January 2019.
The Dividend Aristocrats Index has outperformed the market by 2.7 percentage points a year over the last decade according to S&P.
- Dividend Aristocrats 10 year annualized total return: 9.6%
- S&P 500 10 year annualized total return: 6.9%
What’s more, the Dividend Aristocrats have achieved these excellent returns with lower volatility.
- Dividend Aristocrats 10 year annualized volatility: 14.2%
- S&P 500 10 year annualized volatility: 15.2%
The Dividend Aristocrats have historically provided a rare mix of greater returns with lower risk. They tend to slightly underperform the S&P 500 during bull markets, and greatly outperform during bear markets. Returns in 2008 are shown below as an example:
- Dividend Aristocrats total returns in 2008: -22%
- S&P 500 total returns in 2008: -37%
In the recent bull market, the Dividend Aristocrats Index has slightly underperformed. It underperformed the S&P 500 by 0.2 percentage points in 2016, and 0.5 percentage points in 2015.
There is no one strategy that outperforms 100% of the time.
It’s important to understand why the Dividend Aristocrats have performed so well historically. For a company to have paid rising dividends for 25+ consecutive years it must:
- Have a strong and durable competitive advantage
- Have a shareholder friendly management
These are two very important characteristics when looking for long-term investments. I believe the Dividend Aristocrats Index has outperformed because of these 2 points. A long history of rising dividends is an indication of the two points above.
One of the most common objections to using the Dividend Aristocrats or other long dividend history databases is that it excludes high-quality businesses that don’t have as long of a dividend history (or don’t pay dividends at all).
And that’s a valid point. But the goal isn’t to find 100% of great businesses to invest in, it’s to limit our mistakes by investing where we know we can find great businesses. You don’t have to be right about every stock, just about the few you decide to invest in. Selecting from the Dividend Aristocrats Index makes it harder to make a mistake.
But there’s more to investing than ‘just’ investing in great businesses with shareholder friendly managements and holding for the long run.
Valuation plays an important part… And that’s what the next metric is for.
Number 2: Price-to-Earnings Ratio
The price-to-earnings ratio is calculated as the share price-dividend by earnings-per-share over the last 12 months. It gives a quick snapshot of how much you are paying for a dollar of earnings.
Another way of thinking about the price-to-earnings ratio is how long a company would have to be in business (and not grow) before it would be able to pay its owners back completely (if it distributed 100% of profits).
A company with a price-to-earnings ratio of 10 would take 10 years. A company with a price-to-earnings ratio of 20 would take 20 years. Obviously, the sooner you get ‘paid back’ in this example, the better.
All other things being equal, the lower the price-to-earnings ratio, the better.
Interestingly, low price-to-earnings ratio stocks have historically outperformed higher price-to-earnings ratio stocks. This is known as the ‘value effect’.
Low price-to-earnings stocks tend to have a cloud of pessimism surrounding them; there’s a reason they are cheap.
An excellent example of a cheap Dividend Aristocrat today is Target (TGT). Target is trading for a price-to-earnings ratio of just 10.5. For comparison, the S&P 500 currently has a price-to-earnings ratio of 25.8.
The reasons Target is cheap right now are:
- Questions if it can compete with Amazon (AMZN)
- Lower earnings guidance for its next fiscal year
This has scared many investors away. It typically isn’t easy to invest in low price-to-earnings ratio stocks. You have to be a contrarian – and buy when others are selling.
The reason low price-to-earnings ratio stocks tend to outperform over time is through changing investor sentiment. Target may not be in favor now, but that could change in the future. What happens when/if the company issues better-than-expected earnings, or a higher earnings guidance, or rapidly growing online sales? Good news will send the stock price higher.
For high price-to-earnings ratio stocks – like Amazon which trades at a price-to-earnings ratio of 188 – Good news is already ‘baked in’ to the stock price. If Amazon’s growth slows or it announces some other bad news, the investors that have piled onto the stock for ‘quick growth’ are likely to sell – and send the stock’s value plummeting.
Market darlings always fall to earth at some point. It is impossible for a company to grow at 20%+ a year indefinitely, or the company would eventually consume the world’s entire economy.
Low price-to-earnings ratios are preferred over high price-to-earnings ratios because lower price-to-earnings ratio stocks have historically outperformed. It’s always good to have the odds on your side.
Number 3: Dividend Yield
A long dividend history tells you if a company can sustainably grow over time, and survive (or thrive) through recessions.
A low price-to-earnings ratio tells you a stock is a bargain – that you are not buying into an overpriced security.
The next metric that matters is dividend yield. Dividend yield is calculated as a company’s dividends paid per share dividend by its share price. It is basically the ‘interest rate’ you get for owning the stock.
All things being equal, a higher dividend yield is preferable to a lower dividend yield.
A company’s dividend yield is dependent upon 2 items:
- The company’s share price
- The percentage of earnings a company pays out as dividends
If a company pays out $2.00/share in dividends, and it trades at a share price of $100, it will have a 2% dividend yield. Imagine you decide to hold off on buying because you only want 3%+ yielding stocks (for the sake of this example). If the stock price falls to, say $50 a share, the stock will now have a 4% dividend yield. If you buy at a 4% yield, you are significantly better off than if you bought at the higher price.
The second factor in a company’s dividend yield is what percentage of earnings are paid to shareholders as dividends. This is known as the payout ratio.
Number 4: Payout Ratio
A company simply cannot pay out more than 100% of its earnings to shareholders for long – or it will go out of business. You can’t pay money you don’t have.
The lower the payout ratio, the safer the dividend (on average), but the lower the dividend yield (on average). If a company has a payout ratio of 35% and earnings fall in half, it will still be able to pay its dividend. This is not so for a company that previously had a 90% payout ratio.
Low payout ratios also allow for a company to increase their dividends faster than earnings over the short-term. A company with a 35% payout ratio can double it to 70% (doubling dividends, assuming earnings are unchanged). A company that already has a high payout ratio cannot do so.
Additionally, the lower the payout ratio, the more money a company can reinvest in growth.
There are tradeoffs to payout ratios. The ideal stock would have a low payout ratio and a high yield. This is only possible if the price-to-earnings ratio is low.
Each of the 4 metrics help investors to identify high-quality dividend stocks with strong competitive advantages trading at fair or better prices.
Dividend history is arguably the most important as it helps to identify businesses with strong and durable competitive advantages with managements that want to reward shareholders with rising dividends.
The price-to-earnings ratio is used to find ‘bargains’ – or at least avoid overpaying for ‘story stocks’ that most grow at phenomenal clips to justify their valuations.
The dividend yield and payout ratio tell you how much income you will receive from a stock, and how much of the company’s income is going to shareholders.
The 8 Rules of Dividend Investing uses many of these metrics (and a few others) to identify high-quality dividend growth stocks suitable for investing for the long run.
Investors who stay disciplined and invest only in great businesses when they are cheap are likely to do well over the long run – if those businesses are held to compound your wealth over time.
Disclosure: I am long TGT.