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How To Do Proper Dividend Stock Analysis

 

When determining whether or not to buy an ownership interest in a certain company, there are a number of things that are often considered. Such things include the durability of the company's business model, the company's balance sheet, valuation, and historical earnings growth.

Another important consideration for many investors is the strength and sustainability of the dividend that the company pays out. Dividends are very important, as they accounted for about 42% of the total return of the S&P 500 from 1930 to 2012. The portfolios of many dividend-oriented investors are composed of dozens of dividend-paying stocks from a wide variety of sectors.

In this article, I will discuss the important aspects of each company's dividend, such as the dividend's history, whether or not the dividend can be covered by the company's earnings, and look for clues as to whether the company can continue paying out and growing their dividends going forward.

Dividend Yield

When talking about a company's dividend, the first thing that normally comes to mind is the dividend yield, which is the percentage of your capital that you receive in return over the next 12 months, as long as the dividend amount is not changed. A lot of investors will also use the dividend yield as a way to help determine whether a stock is overvalued or undervalued. If a stock is yielding more now than it ever has, then that may imply that the stock is cheap.

 

Dividend Growth

When evaluating the quality of a company's dividend, there is more to it than just the yield. Sometimes, a company's stock may have a high yield due to poor fundamentals that have caused the price of the stock to fall relative to its dividend payout. These poor fundamentals could then lead to dividend cuts, which can then lead to a drop in your net worth.

Dividend growth is another very important factor. For one, dividend growth helps to preserve the purchasing power of your income stream by protecting it against inflation. Secondly, when a company increases its dividend, that is a sign of confidence by management when it comes to the company's fundamentals and future outlook. And third, growing dividends allow investors to share in the benefits of growing earnings. It should also be mentioned that dividend growth can supercharge an investor's yield on cost over the years. For instance, Warren Buffett and Berkshire Hathaway received a whopping 40% yield on cost in 2012 on shares of Coca-Cola that were purchased back in 1988. This is due to the dividends that grew almost fourteen-fold since the purchase.

Generally, I like to look at a company's average dividend growth rate over the last 5 years in order to see how well the dividend is keeping up with inflation. Some folks like to look back over longer time periods, like 10 or more years, and that's fine too. Stronger dividend growth histories are usually testaments to strong business models, solid economic moats, and pricing power of the companies in question.

Dividend Payout Ratio

In many cases, it's not enough to only look at the dividend yield and the historical dividend growth rates of the stock in question. We need to make sure that the company is making enough money to support these dividend payments. This is where the dividend payout ratio comes into play. It represents the percentage of profits that the company has been allocating toward dividend payments, as opposed to being used for buying back stock or reinvesting into the company's operations. Generally speaking, the lower the payout ratio, the better. This is because lower payout ratios often indicate that there is plenty of room left for dividend increases in the future. Payout ratios that approach or even exceed 100% may indicate dividend freezes or cuts in the future.

When looking at the dividend payout ratio, I like to not only look at what that ratio was over the last 12 months, but also what the company's average payout ratio over the last 4-5 years has been. That way, if the company's current payout ratio is way above or way below that average, then I'll know that I need to do some further research to find out why that is the case.

Keep in mind that companies in some industries tend to have higher payout ratios than companies that operate in other industries. Companies with consistently higher payout ratios usually operate in industries that don't require large and constant investments in infrastructure in order to keep going. They also aren't required to constantly innovate in order to stay at the top of their fields. Because of this, these companies can spend more of their profits on dividends. These businesses include tobacco companies and consumer goods companies.

Dividend Payout Ratio = Dividends Paid / Net Income

How About That Free Cash Flow?

However, there is more to it than just calculating the payout ratio when determining how safe a company's dividend is. This is because the dividend payout ratio is based on the company's earnings. However, earnings don't pay dividends. Cash does. On top of that, earnings often include a lot of non-cash items (depreciation, asset impairments, patent amortization, actuarial pension gains, etc.) that have no bearing at all on a company's ability to pay a dividend. For this reason, it's best to calculate a payout ratio that is based on the amount of actual cash that flows into a company over a given period of time.

When calculating what I like to call the free cash flow payout ratio, I divide the amount of money that was spent on dividends by the amount of free cash flow that was generated by the company over the last 12 months. This tends to paint a more accurate picture as to the safety of the dividend in question. Free cash flow is calculated as the operating cash flow minus the amount allocated to capital expenditures. All of this information can be found on the company's most recent cash flow statement.

This measure really comes in handy when evaluating companies that operate in very capital-intensive sectors of the economy. For instance, consider companies who operate in the telecom industry. In this industry, a lot of money gets spent on infrastructure, which can lead to huge deductions in earnings as a result of depreciation. This can make the dividend payout ratio, as a percentage of earnings, very high. However, when you strip out the non-cash depreciation charges by using the free cash flow payout ratio, a different and more accurate picture of dividend safety is often presented.

And, as with the dividend payout ratio described earlier, I like to look at the free cash flow payout ratio over the past 12 months, as well as over the last 4-5 years, to see if recent data deviates from the norm. I generally like to see free cash flow payout ratios at 60% or below. But, that's just a rule of thumb, and not a make or break requirement.

Free Cash Flow Payout Ratio = Dividends Paid / (Operating Cash Flow - Capital Expenditures)

How To Predict Dividends Going Forward

A lot of folks would end their analysis here, especially after looking at the free cash flow payout ratios. However, these figures are all based on what happened in the past. We need to find some clues as to whether the company can continue paying steadily increasing dividends in the future. The interest coverage ratio, the net debt to equity ratio, and expected earnings per share growth can offer some of these clues.

Interest Coverage Ratio

The interest coverage ratio illustrates the size of the company's pre-tax profits relative to the company's interest payments. Generally speaking, the more debt a company has, the more interest it has to pay, and the less that the company has left over to pay out dividends. The interest coverage ratio is calculated by dividing the company's earnings before interest and taxes (EBIT) by the company's interest payments made over the same period of time. Low interest coverage ratios (usually below 2) generally show that the company is having a hard time just trying to make its interest payments. That may signal dividend cuts or eliminations in the future. The higher the interest coverage ratio, the better. The data used to do this calculation can be found on the company's most recent income statement.

Interest Coverage Ratio = Earnings Before Interest and Taxes / Interest Payments

Net Debt To Equity Ratio

The amount of debt that a company has can ultimately influence the future direction of the company's dividend. Companies that have more debt typically pay more in interest. It should also be noted that at some point, the company's debt will need to be repaid. While many companies are working around this by refinancing the debt at low interest rates, this option might not be as attractive when interest rates head back up. When the company finally does extinguish its debt, it may have an adverse effect on whether it can continue paying dividends.

The net debt to equity ratio can offer us some clues as to how much of a problem debt will be when it comes to paying out dividends. It is calculated by subtracting the company's cash position from the company's short and long-term debts, and then dividing that by the company's equity position. The lower this ratio, the better it is for not only the company in question, but for us as investors. Ratios under one are typically considered to be good. Information used to perform this calculation can be found on the company's balance sheet.

Net Debt To Equity Ratio = Net Debt / Shareholder Equity = (Short and Long-Term Debt - Cash) / Shareholder Equity

Forecasted Earnings Per Share Growth

Dividend growth can be driven by a couple of different factors. One of these factors is the expansion of the company's payout ratio, where the company decides to pay out a higher percentage of its earnings or free cash flow to shareholders as dividends. However, you can only expand the payout ratio so much. Eventually, you must have free cash flow growth in order to pay steadily increasing dividends. And, we all know that free cash flow growth comes from earnings growth. To get a good idea as to the prospects of a company's future dividend payments, it may behoove us to look at analyst projections for future earnings per share growth over the next couple of years. To do this, I like to consult the projections from the analysts at S&P Capital IQ, who produce reports that I can access through my trading platform.

In general, I prefer to see solid high single-digit or double-digit expected earnings per share growth in the years to come. If those projections do come to fruition, then I know that dividend growth should not be a problem.

Conclusion

Now that you have looked at the many different criteria that are used to evaluate the safety of a company's dividend, hopefully you can now use this information to evaluate the dividends of your favorite stock.

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WallStreetBeerMoney.com

"Do Your Own Due Diligence, But By God, Don't Drink Away Your Equity!"

dave@wallstreetbeermoney.com