Updated: Apr 15
So, you’ve found a few dividend paying companies that peak your interest? Maybe it’s a well known blue chip company like Apple. Maybe it's a dividend aristocrat. The problem is, you’ve never heard of them. What metrics should you look at when analyzing a potential dividend company? In the article we’ll take a look at six factors you should consider before purchasing any shares in a dividend stock. These includes:
Table of Contents
I use financecharts.com to do a lot of my research into companies without having to read through individual company earnings statements. The website allows you to view a lot of historical financial data easily. It also allows you to compare multiple stock tickers at once. Lastly, it's free!
Dividend Payout Ratio
Dividend payout ratio is how much of a companies profits are being paid out as dividends. If the company uses a majority of its profits to pay dividends it could slow or stifle growth. At worst, it could make the dividend unsafe to the point where it could be reduced or cut entirely. I look for a payout ratio of less than 60% for safety. 0% is for companies that don't pay any dividends and 100% is for companies that pay all of their net income as dividends. A little variance is normal. A stable payout ratio with increasing dividends is often a sign that earnings are keeping pace with the dividend which is a good sign. Dividend stability is key during retirement. Using dividend payout ratio ensures you understand if a company can continue paying and increasing its dividend. You can calculate it using the formula below:
Dividend paid per share / net income = dividend payout ratio
In the example above we can see the comparison of IBM, Home Depot, and Apple. IBM has continued to increase its' dividend even though its stock price has fallen 12~% over the last five years. You might chose IBM because they have a dividend yield around 4.5% but how sustainable is that dividend since they are over 100% for their dividend payout ratio. This means they are paying more than 100% of their earnings as a dividend. Another example is Apple which has a very low dividend payout ratio. You might overlook them due to their low dividend but Apple has been a HUGE growth stock. In the middle is Home Depot with a good balance of growth and payout ratio. In the end, dividend payout ratio is only one factor you should look at when choosing a dividend stock.
Free Cash Flow
Free cash flow is how much money or profit a company has after it accounts for operating costs. FCF represents the cash available to repay creditors or pay dividends and interest to investors. Debt is a key factor to look at as well when evaluating FCF so you can evaluate how much profit is left over for payments like dividends. A steady or increasing FCF is a good sign that a company’s dividend is safer.
In the example above you can see both Home Depot and IBM have had pretty stable free cash flow. If you looked at this metric alone you would think that both companies are in a similar dividend situation. Adding dividend payout ratio to the mix further shows that HD has room to grow where IBM is already pushing past its' limits. IBM would be a safer bet if their FCF growth was trending upward like Apple's FCF shows. Sustainability for both HD and IBM are in question but HD can continue growth for much longer before they will run into issues. These two metrics are the reason I personally chose not to invest in IBM even though they have an enticing dividend yield.
Operating profit margin shows how much revenue is available to cover non-operating costs like interest or dividends. Essentially it breaks down into what percentage of sales has been turned into profit. For example if a company reports 12% profit margin it means it profited $0.12 on every dollar in sales it generated. Generally, this can be increased by either reducing costs or increasing sales.
Again, we see a case against IBM since their profits have decreased over time. On FinanceCharts.com you can look back further to see that profit margins for IBM have been decreasing since mid-2014. Home Depot has slowly and steadily increased their profits over the last five years. Stable or increasing profits are good sign when looking for competitive dividend companies.
Sales growth is how fast a company has been growing their sales. Typically, you want to see an increase of around 10-20% in sales growth for large cap companies. Sales growth can be an indicator that demand for the companies products is increasing or decreasing.
Using the chart above we can see that Apple makes more sales during Christmas each year. The sales growth begins increasing in July-August, which lines up with the beginning of the school year as well. Additionally, Home Depot has slightly higher sales during the summer. Both of which make sense if you think about the products they sell and what time of year they are bought and used. Understanding a companies products can help you understand trends in its' sales. Buying at a low point in sales could help boost your return on investment slightly vice buying at the high point. Again, we see IBM has decreasing sales growth over the last five years. Another strike against its' dividend sustainability.
Trailing Price to Earnings Ratio
The price to earnings ratio compares the current share price to earnings per share (EPS). This is used to determine the stocks relative value. The P/E ratio can be used to determine whether or not stock is undervalued or overvalued. This ratio is the rough amount an investor is willing to invest to receive $1 in earnings. For, example with a P/E of 20, an investor is willing to invest $20 to earn $1 in earnings. A high P/E ratio could mean that investors believe the company is going to increase its earnings in the future and vice versa for low P/E ratios. On average I look for 20 P/E ratios and below in dividends stocks but that might be hard to find in today's market. Review P/E ratios across companies in the same sector to see what that sector's P/E average is compared to your chosen company's. You can also compare the company's P/E ratio to major indexes and their P/E ratio to get an average.
Using P/E ratios to determine if a stock is undervalued or overvalued can be done using the 3 year, 5 year, or 10Y P/E averages. If the current P/E ratio is above the average then the company could be over valued. If the current P/E ratio is under the average then the company could be undervalued. Using this information we can see that Apple, Home Depot, and IBM are all currently overvalued. Does that mean you shouldn't invest in them? That's up to you and whether you believe the companies earnings will continue to rise to keep pace with the share price. Reviewing what we have seen above during our analysis I would agree that Apple and Home Depot will likely keep pace. Apple is overvalued by a much larger margin so it's riskier. IBM being over valued doesn't jive with the information we've seen thus far.
Dividend CAGR (Compound Annual Growth Rate)
What's great about dividends is that your capital investment (share price) and your dividends can grow. Dividend growth helps you get more income from the same amount of shares. For example, if you were getting $1000 from dividends in 2020 and the company grew its dividend by 8% you would get $1080 in dividends without purchasing more shares. Now, imagine you're in retirement and earning $30,000 in dividends. That 8% could be equal to $2,400 or $200 more income a month! Dividend growth can drastically increase your yield on cost. Yield on cost is your dividend yield using your cost per share instead of the current share price. The yield on cost formula is:
Current Dividend / Your Cost per Share = Yield on Cost
Warren Buffet invested in Coca-Cola in 1988 and his company owns around 400 millions shares which is $1.299 billion. His yield on cost in 2021 is 52%! If you want to learn more about dividend yield, check out this post.
It important to see the CAGR of a company over time. You can see that IBMs dividend growth has slowed to an average 1.45% over the last three years. It appears they slowed their growth due to the financial situation we identified above. There is a huge difference in CAGR between Home Depot and IBM. IBM might have a higher dividend yield than Home Depot but your dividends would grow roughly 12 times faster with Home Depot! I look for a CAGR of at least 8%+ in my dividend paying companies.
We looked at six factors you should analyze when choosing a dividend paying company. Each factor is a small chapter in a big book. You have to read the entire story to understand what is going on inside a company. There are more factors you can consider and these are only a handful of tools for your toolbox. I hope that they help you on your journey for financial freedom!