I thought it would be a good idea to follow up part one of my primer on dividend growth stocks with second part, that is all about some of the basic criteria that can be used to evaluate a dividend growth stock that you’re interested in. If you are going to evaluate whether to buy an individual stock or not, you need to have some kind of objective criteria established. If the stock meets your criteria, you consider buying it. If it doesn’t, you move on and keep looking. Read on to learn about some of the criteria that should be examined when determining whether or not to consider buying a stock.
10+ Years of Consecutive Dividend Increases
Since I am interested in purchasing dividend growth stocks, I want to see a history of rising dividends. Generally I look for 10 or more years of consistent dividend growth. I will occasionally consider 8 or 9 years of dividend growth if I have other reasons to like the stock.
Current Yield
Yield is calculated by taking the current dividend payout and dividing it by the current price of the stock. You can think of is as what percentage of your investment will be returned to you each year if you purchase the stock. Kind of like how the bank pays you interest on the money deposited there.
The yield at the purchase price becomes the yield on cost as soon as the stock is bought. The general sweet spot for dividend yield appears to be between 3.0% and 5.0%, much closer to 3.0% for most stocks. Utilities and telecom stocks often have yields closer to 5.0%.
- > 3.0% yield – Good.
- 2.5-3.0% yield – I’ll consider purchasing the stock if other factors strongly encourage it.
- < 2.5% yield – The stock’s yield is too low for me to consider buying at this point.
As yields go higher there is a chance that the stock is what’s called a dividend yield trap. To quote Admiral Akbar – “It’s a trap!” If you recall, the divisor in the yield calculation is the stock’s price. So consider a stock with a yield of around 3.5%. Not bad. But what if the company is on a slow downslide? The dividend payout stays the same, but every year the price of the company’s stock drops and drops. Consequently the yield goes up and up. Now the yield is at 9%, but the company is basically a failing business. In a few years time you may be faced with a dividend cut and a reduced share price – a lose-lose situation if there ever was one.
Of course, the yield might be high because the market just had one of it’s spasms where speculators freaked out and sold out. In this case, the stock is a prime buying opportunity.
It’s up to you, the investor, to do some research and figure out why that yield is high.
Finally, as dividend growth investors, we would like to see the yield on cost of our stocks continually rising. But there is nothing that says that a stock must increase it’s dividends. Dividend payouts can remain the same or even be cut.
Price/Earnings (P/E) Ratio
The P/E ratio is calculated by dividing the current market price per share by the EPS. This ratio can give you a rough idea about whether a company is attractively valued or not.
- P/E <15 – Good.
- P/E between 15-20 – A little high, but acceptable.
- P/E >20 – I won’t purchase the stock if the P/E is 20 or greater. The stock is likely overvalued.
Earnings Per Share (EPS)
You can think of earnings as being how much profit did the company bring in each year. Thus earnings per share is the amount of profit divided by the number of shares. Generally, EPS should be higher than the dividend per share. Otherwise the company is handing out more money in dividend payments then it is making. This would not be a good sign.
Technically, EPS is calculated by (net income – dividends on preferred stock)/shares. Preferred stock holders get paid first, then common stock holders.
EPS Growth
In order for dividends to keep growing, EPS should be growing as well. Generally I look at EPS growth over 5 and 10 year time periods. Looking at both the 5 and 10 year periods will give you an idea about whether EPS growth is accelerating or decelerating. I also try to account for recessions, since EPS is very likely to decline in poor economic times.
Revenue and Revenue Growth
While EPS focuses on net income, revenue is all about gross income. Why should you look at both? EPS can still increase while revenue remains flat or even decreases if the company cuts costs by way of layoffs, for example. It’s best if EPS growth is matched with revenue growth. Of course, you will need to factor in the economic climate in order to properly assess changes in revenue.
Dividend Growth Rate
Dividend growth stocks are supposed to grow their dividends over time. But there is nothing in the definition that says by how much they should grow them. Dividends should grow at least as fast as inflation (~3%/year). Below this rate, consider looking elsewhere.
I look at the 5 year and 10 year growth rates. By looking at the 5 and 10 year growth rates, you can get an idea about whether dividend growth is accelerating or decelerating. You can use the rule of 72 to get a quick estimate of how long it will take for the dividend to double based on the growth rate. Just divide 72 by the growth rate. A growth rate of 7% means that the dividend will double in about 10 years.
Payout Ratio
The dividend payout ratio is calculated by taking the dividend per share and dividing it by the EPS. The lower the payout ratio, the more room there is for the dividend to grow over time, the more of a cushion protects the dividend in the event of an economic downturn, and the more money the company has available to invest back into it’s business. All are good things.
- <30% – Awesome.
- 30%-50% – Okay.
- 50%-65% – I’ll consider it.
- >65% – Probably better to look elsewhere.
The above guidelines are very general. Different industries have different norms for payout ratios. For example, it is not uncommon for utilities, telecoms, and tobacco companies to have higher payout ratios. So in addition to looking at the payout ratio for a given company, you should look at the payout ratio of several of it’s competitors to get an idea of the industry standard.
Price vs 52 Week Range
I would prefer to buy stocks that are closer to their 52 week low. But I don’t consider this essential if other indicators suggest that the stock is well valued. After all, my favorite holding period is forever, so I try not to pay much attention to short term fluctuations in stock price.
Read the News
This one is pretty simple. Just got and read some recent news, press releases, and blog posts related to the stock you are considering buying. This is a great way to uncover potential problems that may be brewing. Of course, you have to use your own judgment to determine how much faith to put into any given opinion.
Additional Screening Criteria
I would consider the above list to be the basics. If a stock doesn’t meet these, I don’t consider it. You can do pretty well starting with the basics, but lots of people, including myself, may add additional screening criteria. Some of the one’s that I’ve seen or used are:
- Dividend discount valuation models
- Technical analysis
- Insider trading
- Additional Ratios (e.g. Price/Book, Return on Equity)
- Rating service recommendations (e.g. S&P, Morningstar, Ford)
Readers: What criteria do you use when picking a stock? Do you use different criteria when looking at different types of stocks (common stock, REIT, MLP, etc.)? Do you use different criteria for different investment strategies (long term, short term, high yield, etc.)?
My Journey to Financial Independence 