There are numerous metrics that one can examine when considering a stock purchase. Three numbers are especially helpful to the dividend investor.
Dividend investors, by nature, look for stable companies to add to their portfolios. Wild swings and monster gains are fine for the speculation crowd, but for the dividend investor concentrating on retaining one’s wealth is of paramount importance.
There are some things one can look for in a company during the examination stage that can help act as an in/out decision to cull companies that will not work in the portfolio. Companies that do not make this grade might be acceptable for further examination and possible inclusion in an alternative strategy one might be considering.
Four of the companies in my portfolio are Aflac, Aqua America, 3M and Johnson & Johnson, and I made the decision a while back to use them as examples in these articles. They have worked well for me over the past couple of decades, but whether or not one should include these companies in their own portfolios is a completely different issue. I seriously do not want to offer stock picking advice.
As I go through each of the considerations that one should have when seeking companies for inclusion in their dividend investing portfolio, I will use these companies as examples.
Of course, the dividend yield is the first thing on any dividend investor’s list of things to examine. If a company is not offering much of a dividend then as far as dividend investing is concerned, the company may be tossed from consideration. After all, dividend investors do need an attractive dividend.
Very generally speaking, the higher the dividend the better. Whenever I make a statement of this sort I am impelled to immediately follow it with an explanation that high dividends are not necessarily a good thing.
Simply chasing high dividends, while a strategy, introduces a large amount of risk into a portfolio. This is because a high dividend yield can simply be the result of a drop in the price of the stock. A falling price can be a good entry point, it can merely be a correction from unrealistic expectations, or among many other possibilities it can be a sign of a company’s decline.
One needs to have full understanding of the reason for the high dividend yield before continuing with the consideration of the company. Too often an unrealistically high dividend yield is suspended or drastically cut, leaving the investor who purchased the stock just for the dividend hanging (think General Motors, Kodak, Rite Aid, or a myriad of other examples).
Below we look at the current dividend yields of our example companies.
|Johnson & Johnson||2.54%|
At this moment the average dividend yield of every company in the market is 1.68%, so all example companies are above that average.
Oftentimes the company’s sector makes a difference. NYU.edu maintains a very detailed breakdown of all U.S. stocks, placing them into 94 sectors. Looking at their Dividend Fundamentals by Sector we can get the average yield per sector.
|Johnson & Johnson||Drugs (Pharmaceutical)||2.27%|
|Aqua America||Utility (Water)||1.56%|
In our example companies, only Aflac’s dividend yield lags their industry. If one were looking for a dividend yielding company in the Life Insurance sector then this would be something to keep in mind, but certainly should not be a single reason for not considering.
The dividend payout ratio is the annualized dividend rate divided by the annual earnings per share. This ratio is an indication of the amount of earnings that are returned to the investor, with the remaining amount available for reinvestment, paying off debt, and other company necessities.
Used by itself, this number is less meaningful than combining it with other considerations. On the one hand, the lower the payout ratio the more the company can use for growth, on the other hand, the higher the ratio the more dividend investors get in the immediacy. There is a balancing aspect here.
This number can vary widely. New companies and small capitalized companies usually hold onto their cash reserves so that they have resources to grow. Higher payout ratios are generally offered by more stable companies that wish to reward their owners.
As above noted, dividends are sensitive to the sector they are in, so we examine the numbers of our example companies in comparison to their sectors.
|Company||Sector||Payout Ratio||Sector Payout Ratio|
|Johnson & Johnson||Drugs (Pharmaceutical)||43.8%||61.4%|
|Aqua America||Utility (Water)||66.7%||66.6%|
Whereas two of these companies are right on mark with their sector averages, Johnson & Johnson offers a lower ratio than its sector and 3M a considerably higher one. The Johnson & Johnson number is not the concern 3M is, which wildly varies from the average. Numbers that are way out of bounds need to be examined to see if the variance is telling us anything meaningful.
It might be instructive to look at other companies in the Diversified sector and examine their payout ratios. The NYU.edu page offers a listing of the companies in each sector, and after removing the OTC companies as well as those that do not offer a dividend, we have the following.
|Company Name||Payout Ratio|
|3M Company (NYSE:MMM)||63.30%|
|Carlisle Companies Incorporated (NYSE:CSL)||32.15%|
|Compass Diversified Holdings LLC (NYSE:CODI)||100%|
|General Electric Company (NYSE:GE)||6.15%|
|Honeywell International Inc. (NYSE:HON)||44.90%|
|Jefferies Financial Group Inc. (NYSE:JEF)||37.90%|
|Roper Technologies, Inc. (NYSE:ROP)||17.40%|
By their very nature, companies in the Diversified sector may be all over the map as far as payout ratio is concerned. As for 3M, it has five segments - Industrial, Safety & Graphics, Health Care, Electronics & Energy, and Consumer. Each of these segments could be in its own sector, so if one wanted to get nitpicky about these numbers then they could figure the payout ratio for each of these segments, but that would certainly be overkill.
A nice dividend is fine, but what about the future? Will the dividend be stuck where it currently lies or will it be increased over time? Nobody can absolutely predict the future, but looking at past history can offer an indication as to how important the company sees their dividend.
Best is to look not only for a history of dividends, but dividend growth. Companies that only increase their dividends occasionally are unlikely to offer the stability of an increased dividend every year. Our example companies all have histories of increasing their dividends over the long haul. Nadsdaq.com offers the information for our table.
|Johnson & Johnson||$3.73||$3.54||$3.32||$3.15||$2.90||57|
|Aqua America||$0.91 **||$0.85||$0.79||$0.73||$0.69||27|
Perhaps I could have skipped making the calculations in the above table and simply said that these companies are Dividend Champions. Dividend Champions are companies that have increased (not just maintained) their dividend every year over the past 25 years, meaning that they continued to do so through numerous recessions. The column on the right shows the number of consecutive years each company has increased its dividend. That is real dedication to the dividend.
Associated with dividend growth is the dividend growth rate. This is the annualized percentage growth of the dividend over a specified period of time. It is an important number because it tells us the degree to which the dividend is being raised.
Companies that show strong dividend growth tend to have characteristics that are positive from a fundamental perspective. They generally have good cash flow, can handle the debt on their books, and continue to be increasingly profitable. A strong rate forces financial discipline on the company to ensure that the expected quarterly paybacks to investors are maintained.
Below is a dividend growth table of our example companies for the three time periods most commonly used. The information was taken from the latest Dividend Champions spreadsheet.
|Company||3 Year||5 Year||10 Year|
|Johnson & Johnson||6.0%||6.3%||6.9%|
All companies listed are showing strong dividend growth over the years, so it is likely that this trend will continue. A stable and increasing dividend growth is essential to the dividend investor.
It is important to consider many things when selecting a company to purchase and hold over a long period of time. While there is no single number that should be used to make the decision, three aspects of dividend investing – dividend yield, dividend payout ratio, and dividend growth – are the keystones of company evaluation. Taken together, they can start to build a case for or against a purchase, and should be followed with a close examination of the other aspects of the company.