Before investing in dividend growth stocks it is important to do your research. You need to analyze the stock to determine the company’s strength, future potential and current valuation. You need to make sure the company that you may invest in is a well run money making machine that can hopefully pay you increasing dividends for years to come. In this article I will take you through my process of analyzing a stock to determine if I believe it will be a good long term investment.
When analyzing stocks it is helpful to have resources of financial data to help quickly identify good stocks. On resource I use for every stock analysis is Value Line. Usually you can find updated Value Line analysis at your local library. This is where I usually will copy the pages I need to use for my own analysis. I also gather some information using the Standard & Poor’s Stock Report provided by my broker (check your broker for access) and from Yahoo! Finance.
Below you will find the different metrics I use to determine a company’s strength and future profitability. I will usually work up a full report and compare the reports of different companies to determine which ones I believe will be the best to invest in.
When looking for stocks to invest in one of the first things I look for is annual dividend growth. I like to invest in companies that have a history of paying out dividends and increasing those dividends year after year. You can find these from lists of companies with dividend growth history. For stocks that you want to consider investing in, examine the recent history of dividend increases. Calculate the growth rate of the dividend over the past few years. Typically I will calculate the compound annual growth rate of the past 5 or 10 years using this online calculator. I also calculate the growth rate year over year of the last couple dividend increases. This gives me an idea if the company is slowing down or increasing their dividend growth rate in more recent years. I like to look for dividend growth above 8% or so.
Earnings Per Share (EPS)
The next metric I want to analyze is the company’s earnings per share history. Look for companies that have consistent and increasing earnings per share. We do not want to invest in companies who have erratic earnings that are hard to predict. One or two down years may not rule a company out but generally over the past 10 years I like to see an upward trend in the EPS. It is important to calculate the 5 or 10 year compound annual growth rate for EPS using the same online calculator. Also calculate the growth rate year over year of the last couple years. Compare the EPS growth rate to the dividend growth rates you previously calculated. If dividends are growing faster then EPS this is not sustainable for the company. Since dividends are paid out of the companies earnings, we want to see earnings growing at the same pace or faster then dividend payments.
Another key figure I look at is net profits of the company. How much money is the company making. Analyze the past 5 to 10 years worth of net profits to determine if management is taking the company in the right direction. Like EPS we want to see a consistent upward trend in the net profit numbers. When a company pays a dividend it is paying out a portion of their profits. We want to make sure profits are growing so that the company is able to continue growing dividends. It is important to compare the growth rate of net profits to the growth rate of the EPS and dividends. If profits are growing slower then dividend growth then this leads me to believe that the dividend growth rate will have to slow in the future.
Next I want to look at the growth of revenues. A company may be increasing their net profits because of cutting expenses. However you can’t indefinitely increase profits without sales revenue growth. Therefore I want to see a company consistently increasing their revenues. I calculate the 5 and 10 year growth rates again to compare to the growth rates of profits, EPS and dividend growth. Most of these growth rates should be fairly consistent with each other. A company that is growing revenues should also be growing their net profits unless expenses are growing at a faster rate. This is something we want to make sure is not happening.
It is important to see that the companies outstanding shares count is either staying consistent or decreasing. A decreasing share count means the company is buying back shares. When a company buys back shares, the remaining shares then each represent a larger portion of the company. With less shares outstanding, my shares are give me a larger portion of the earnings. I want to make sure that shares outstanding are not increasing. This could be happening because the company is awarding bonuses to management or raising new money through secondary share offerings. Either way as more shares enter the market they are diluting my current ownership. I don’t want my ownership to be diluted.
Return on Equity
Return on equity measures a corporation’s profitability by calculating how much profit a company makes with the money invested by shareholders. Return on equity takes into account the retained earnings from prior years and therefore lets investors know how effectively management is reinvesting their capital. Typically I look for return on equity of at least 12% and I either want this number to stay consistent or increase. It is valuable to compare companies within the same industry to determine how a specific company is doing. You cannot compare companies within different industries because different industries will generally operate at different returns on equity. It is important to note if there is a downtrend in return on equity because we will generally want to stay away.
The current ratio is a test of a company’s short term financial strength. The ratio calculates how many dollars in short term assets would be available to cover short term liabilities coming due within one year. I look for a company’s current ratio to be above 1 so that I feel confident the company won’t have short term liquidity troubles.
Net Profits to Long Term Debt
I want to make sure that the company does not have too much debt that will cause future problems. Compare the net profits of a company and thier long term debt amount. Long term debt should be less then five times net profits. This will mean that if the company used all thier net profits over the next five years they would be able to eliminate all long term debt. While debt is not necessarily a bad thing, I want to make sure a company has not taken on so much debt that it will cause problems in the future. If a company is struggling to service it’s debt one of the first things they will be forced to do is cut thier dividend in order to use that money for debt repayment instead.
The payout ratio is a measurement of how much of the profits of a company are being paid out in the dividend. If a company has $1 in EPS and a dividend rate of $0.50, it’s payout ratio would be 50%. A lower payout ratio generally means the dividend rate is more safe from future cuts then a high payout ratio. The payout ratio fluctuates between industries. Certain industries like tobacco companies will have high payout ratios because they don’t have many opertunities to grow thier business so they pay out most of thier profits to thier shareholders. Other industries like technology may still have opportunities for growth so they will retain some of those profits in order to invest in those opportunities. Compare the payout ratios of companies within the same industries to determine if they are too high or at an OK level.
Dividend growth stock investors can determine thier own criteria for a required dividend yield. Generally I prefer a dividend yield of at least 2.5%. I may consider a slightly lower yield if thier is high dividend growth rate. Typically I try to diversify by investing in some companies with a higher dividend yield (but most likely lower growth rate) and some other companies with a lower yield (but more likely higher growth rate). This gives me a good overall balance in my portfolio of dividend yield and dividend growth rate.
These are the metrics I use to determine if I would like to invest in a particular company or not. Once I have determined that I think it is a more secure, dominate company with great management I will look to determine if I believe the company is currently undervalued, overvalued or fair valued. I will project earnings forward and determine if I believe this company will offer me a good return for my money in the upcoming years at it’s current price.
Every Friday I plan on doing an analysis of different companies to determine if I am interested in investing in them. I will post my analysis on this site along with my current valuations so you can see my thinking and offer your own inputs.