There are just as many ways to pick dividend stocks as there are stocks themselves and an entire book could be written on the subject. I have seen every screen and every method with some as simple as looking for cheap value and others as complex as large computer programs.
Fortunately, there are a few concepts that have stood the test of time and are basic enough that anyone can understand them. Our hope is that you will become a better dividend investor by getting a firm understanding of these concepts.
Understand the business
One of the most adept investors of our time, Warren Buffett of Berkshire Hathaway, holds to the most basic and intuitive investing idea. Understand the business and invest as if you were buying the whole company.
Many investors throw their money at hundreds of stocks without any research at all, hoping that the winners will compensate for the losers. They see breaking news or read a short article in the financial press and figure, “why not? It’s only a few thousand dollars.” They end up with a portfolio that is not aligned with their return needs and never meet their financial goals.
An investors only needs 30-40 stocks for a diversified portfolio and maybe fewer if they invest in funds that hold many companies themselves. By investing in fewer companies, an investor should have the time to do research and understand the business.
When Warren Buffett says he invests his company’s money only in businesses the board can understand, he isn’t talking about hiring NASA scientists to be able to understand a complex business model. If a business is so complex or subject to constant change that the average business person cannot understand it, then it won’t be in the Berkshire portfolio.
This is why you find names like Coca Cola (KO), Johnson & Johnson (JNJ) and Walmart (WMT) in Buffett’s portfolio. They are relatively simple business models and almost none compete in multiple industries. They sell one product or service and they do it very well.
One of the most important concepts of understanding a company’s business is being able to assess its competitive advantage in the industry. This has a lot to do with understanding the industry or sector in which the company operates which is why Buffett invests most of the portfolio in just a few sectors like consumer goods, financials and utilities.
A good start to understanding an industry is by analyzing Porter’s Five Forces model of competition. The model includes five traits of competitive forces. If you can answer the five questions for the industry as well as the company in which you might invest, then you know the business.
- How much bargaining power does it have with its suppliers?
If the company is a large buyer or one of the few that buys a particular product, it will have more bargaining power with suppliers. Similarly, if there are many individual suppliers for the same product then the company will be able to choose whichever offers the most attractive terms.
The companies in Warren Buffett’s portfolio all have a dominant share of the market in their industry. That means they have more bargaining power on suppliers because they are generally the largest buyers in the market. They can get better price or credit terms and can demand better quality for the supplies they purchase.
- How much bargaining power does it have with its customers?
This question shares the same ideas as the previous but from another perspective. If the company is one of only a few that sells a product or if there are many individual customers, then it will be able to demand higher prices without worrying about losing a few customers in a pool of many.
All the companies in Buffett’s portfolio have incredibly strong brands and customer loyalty. They sell things that people want to buy over and over or provide the services that customers cannot live without. This means they can increase their prices without being afraid that their customers will go to a competitor. This kind of customer loyalty and brand identity is usually a product of decades of marketing and customer satisfaction, which is why you’ll find few start-ups in Buffett’s portfolio.
- Is there a constant threat of new competition in the industry?
This is one of the most important questions for an industry or company. The constant threat of new competitors will force a company to cut prices, increase advertising and will generally lower profits. Companies in the industry can avoid this by having a size or patent advantage that protects them from new entrants.
The companies in which Warren Buffett invests are all in relatively protected industries where there are strong barriers to entry. Within the utility sector, these barriers are legal and many of the companies have a monopoly in their market. In other sectors, the costs of production and marketing would be so high that only multi-billion companies could enter the market. Take Coca Cola and the soft-drink industry for example. There are just a few large competitors in the market and each has a very recognizable brand and strong customer loyalty. A new competitor would not only need massive production facilities but would need to spend hundreds of millions in marketing to break into the industry.
- What is the rivalry among existing competitors?
Competitive rivalry within the industry shares a lot of the same ideas as the threat of entrants and can be a double-edged sword for a company. If there are many competitors selling a relatively similar product, competition will be high and profits will be low. If there are only a few competitors and competition is low, profits will be higher but it could attract new companies into the industry. The best scenario, and one in which many of Buffett’s companies find themselves, is an industry with only a few competitors but highly competitive between them. That way, the fewer competitors can more easily control the market and avoid a price war between companies but modest profits do not necessarily attract new competitors.
- Is there a threat that another product can substitute for the company’s product or service?
Substitute products can be just as bad as new competitors in the industry. Some industries like soft-drinks may have many possible substitutes within the beverage category. Other industries, like water utilities really have no substitutes.
Some companies in Buffett’s portfolio have found a way around substitution by offering all the substitutes themselves. Coca Cola not only sells soft-drinks but also has it own line of bottled water and juice drinks. This allows the company to worry less on one individual product and focus on a product category. Coca Cola can use its size and brand strength to dominate the entire beverage category instead of just carbonated soft-drinks.
Dividend Fundamentals
Fundamental analysis refers to looking at the financial data provided by the company to assess its strength relative to competitors and its prospects for future growth. As with any kind of stock analysis, there are a million and one data points to look at but a few basic ideas are all an investor needs to pick good companies that can provide a steady income and price returns to a portfolio.
Valuation multiples are some of the most closely followed fundamentals. We will cover them in the next section so will not spend too much time here. These measures are usually a comparison of the stock’s price with another fundamental factor like earnings, sales, cash flow or enterprise value.
Margins are an important metric to follow, especially a company’s margins relative to peers. The three margins from the company’s income statement are:
- Gross margin is the percentage of sales left over after paying for the cost of materials.
- Operating margin is the percentage of income left over after all operating expenses have been taken out of sales. This is one of my favorite fundamental metrics because it shows how well management operates the business, growing sales while keeping operating costs under control.
- Net margin is the percentage of income left after taking out all income statement items from sales.
Dividend yield is obviously extremely important for a dividend portfolio. Since the general market offers a yield of around 2%, I like to see yields above 2.5% for my dividend stocks to show management’s commitment to returning cash to shareholders. I also like to see a payout ratio of 75% or less, though 65% or less is even better. If a company is paying out more than 75% of its income as dividends, it may have a tough time increasing the dividend payment without a strong boost to income or may even have trouble maintaining its dividend if sales decline.
While past performance isn’t a guarantee of future returns, history is usually a good guide of management’s ability and the company’s commitment to returning cash to shareholders. I have developed a proprietary system, the historical performance rating system, which ranks companies on a series of dividend and performance-related factors.
The system looks for dividend yields between 2% and 20%, for a range that can put a meaningful amount of income in your pocket but is not so high as to be primed for a dividend cut. Free cash flow yield, the free cash flow divided by the stock price, is an important metric because it tracks the company’s ability to pay its dividend.
Dividend growth is the most important factor in my model with only those increasing their dividends by more than 7% over the last five years receiving a top score on the scale. The system also measures income growth over the previous three years and looks for companies with a payout ratio of 65% or less.
While I have a laser-focus on dividends, no investor can ignore price return so the system also tracks the twelve-month return for stocks. Collecting a sky-high dividend is a hollow victory if the price of the shares falls to the basement.
I have incorporated many of these factors in the dividend stock screener on the DividendLadder website. The screener allows you to search separately for dividend stocks, REITs or MLPs. Within each category, you can screen for the price-earnings ratio, yield, free cash flow yield, dividend growth, income growth, payout ratio, one-year return and the HPR rating.
More Information Here: Top Ranked Dividend Stocks
Valuation
Valuation of stocks seems like it should be one of the simplest and most intuitive concepts in investing. Buy low and sell high is the simple mantra. It is rarely as simple as that and there are many different models by which to measure a stocks fair value and its value relative to peers.
The first, and probably the most commonly used, metrics are price multiples. These are simply the share price divided by another per share amount. Common measures are by earnings, sales, cash flow or book value. The price-to-earnings ratio (P/E) is the most common of the group and makes sense because earnings are supposed to measure the profit to owners of the company so the ratio measures how much investors are willing to pay for each share of those profits.
There are two important concepts you need to remember when using price multiples. One is that the multiple can be compared to competitors and their current multiples or to the company’s own stock history. Are the shares relatively expensive or cheap compared to other companies or to its longer-term average?
The other important concept is that the price multiple is a relative valuation method. It measures the stock’s price against itself or another stock using the same measurement.
Price multiples will not tell you what the fair value of a company is or how much you should pay for the shares. The fact that a company’s shares trade for 15 times its earnings may mean that it is relatively cheaper than a stock trading at 20 times earnings but that does not necessarily mean it is a good buy. The stocks in the sector or even the whole market may be overvalued so buying the cheapest ones may still be paying too much.
Comparing a stock’s P/E multiple with its own average over a longer period may help decide whether it is over- or under-valued but investors will need to use other methods to determine fair value. Further, understand the differences between the price multiples. Because earnings can be easily manipulated by carrying forward or delaying expenses, the price-earnings multiple may not be the best method. Price to some kind of cash flow is usually a cleaner ratio but also has its limitations.
Many dividend investors prefer a dividend yield method of valuation. Since income is the focus of the portfolio, it stands to reason that it should be used as a decisive point whether to buy a stock or not. The idea makes intuitive sense as well. The dividend yield is the current payout divided by the share price so if a stock’s share price has outgrown its value then the yield would be relatively low and may not make the cutoff.
Many investors measure yields by sector and by the company itself. If an investor just set an arbitrary dividend yield across all stocks, then their portfolio would be overweight certain sectors like financials and utilities. The portfolio would miss out on growth in other sectors and leave risk for a big loss if challenges arose for specific sectors. Within the sector or industry itself, compare the dividend yield with peers and with the company’s own history for a more robust measure of current valuation.
Another popular valuation method, and one that helps determine a fair value for stocks, is the discounted cash flow (DCF) approach. The method requires some calculations and an understanding of cash flows and cost of capital so you may need to spend some time researching the procedure. An example will help understand the basics.
DCF valuation always starts with analyzing the company’s ability to grow dividends in the future. I have used two growth periods in the Walmart example above but you can use one or any number of periods. The dividend growth rate is based on historical growth and your assessment of the future cash flows. On a historical growth rate of 14% but estimates for slower growth in profits, I estimated that the company would be able to grow its dividend by 12.5% annually for the next five years and by 10% annually for the five years after that. You also need to estimate a rate of growth that the company can maintain into perpetuity. This should realistically be close to the natural rate of growth in the economy but opinions vary. My own estimate was for a 4% terminal rate of growth. The calculations are not shown but each year’s dividend is increased by the assumed rate of growth.
Next, you need to estimate the cost of capital for the company. In finance terms, the cost of capital is the required return to go forward with a project. If the returns on the project to not meet or exceed its interest rate cost then there is no sense making the investment. The rationale is the same with investing in a company. The future value of cash flows should be discounted by the cost of the company’s capital structure. This means finding the company’s relative cost of equity and the cost of debt and then weighting them by the amount of debt and equity used to finance the company.
Walmart issues 10-year debt at 3.4% and uses it to finance 42.6% of the company. The cost of equity, found by using the Capital Asset Pricing Model or some other approach, was estimated at 5.8% and weighted with the remaining 57.4% of the capital structure. The calculations are not shown but each year’s dividend is discounted by the cost of capital and the appropriate years to the payment, i.e. a series of discounted cash flows. This is done to find a present value of each year’s cash flow. Once all the present values are added up then you will have an estimate of the fair value of the shares in the market today.
It is a complicated procedure but very popular because it can help you find a justifiable price to pay for stocks. You will probably need to read into each part of the process before you are comfortable with the method but it is well worth it. An important note is that the model is highly dependent on the assumptions you make for dividend growth and the discount rate. Depending on your tolerance for risk, you might make your assumptions and then lower the growth rate or increase the discount rate slightly for a more conservative estimate of the share price.
Forward Expectations
The ultimate value of a stock is the future growth and cash flows you will receive so forward expectations are another important valuation concept. Spend enough time researching a company or an industry and you will get a good feel for what is possible as far as margins and sales growth. Along with a perspective on growth in the general economy or other macro-level drivers and you can start to build your own estimates for earnings or cash flow growth at a company. It is a formidable task and even Wall Street analysts do not do it alone. Look at estimates for economic growth and expectations for the company itself from several analysts. This can help guide your own expectations.
I would caution you on relying too much on analyst or market expectations. Two problems exist with Wall Street’s expectations for earnings and stock prices. First, many analysts need to protect their relationship with company management to have access for interviews and so the banking division of their own company might do business with the subject company. This usually leads to optimistic assumptions and estimates and few recommendations to sell a particular company are ever issued.
Another problem is the natural optimism that seems to pervade the markets. Few ever expect the economy or earnings in the market to plunge until they actually do and a recession occurs. People generally forecast a continuing rise in economic growth and corporate earnings into the future. Investors need to look at the facts objectively and decide if they want to build in a little more conservatism into their own expectations.
While most people use relative valuation methods like the price-earnings multiple based on earnings over the last twelve months, you will also see this multiple based on forward earnings expectations. That means making an estimate for earnings over the next year and then dividing the current share price into that estimate. The problem is that many investors use forward expectations and price multiples as a way of rationalizing high current prices. They reason that, though the price multiple on the previous year’s earnings is high the price multiple on next year’s earnings is reasonable so the stock is still a buy. The problem with this is forward expectations tend to creep up until the current stock price is justified. When the inflated expectations are not met, the stock doesn’t seem like so great an investment.
