I would then look at trends in stock prices, earnings per share, dividends, and dividend payout ratios over the preceding decade.
Right under earnings per share, I typically try to discuss qualitative factors that might drive future profitability. I believe that rising earnings per share is the fuel behind future dividend increases. The rising stream of earnings per share also allows for growth in intrinsic values over time. I am not a big fan of stagnant earnings per share, because this shows me that there is natural ceiling for future dividends to grow. Therefore, I am losing purchasing power for my dividend income and intrinsic value over time. While some higher yielding companies tend to have low growth in earnings per share, but compensate with the high dividend, I still want some growth in the future.
We also want to review the quality of earnings over time. The trends in earnings per share should show you how cyclical those profits are over time. For cyclical companies, earnings per share are their highest at the top of the economic cycle. Therefore, P/E ratios are relatively low and these companies appear cheaper than they really are. We want stable and dependable earnings as much as possible. A historical review, coupled with a qualitative understanding of the dependability of the business model throughout the economic cycle, is important.
I tend to review trends in dividend payout ratios, in order to determine dividend safety. As an investor whose goal is to live off dividends in retirement, dividend safety is of paramount importance. Once you hit the dividend crossover point, which is the point where dividend income exceeds your expenses, you are good to go as long as the dividend is stable and growing over time. The goal of the dividend investor is to stay retired no matter what happens in this unpredictable world. This is why I not only want a dividend payout ratio that is generally below 60%, but also want a growing dividend that is supported by growth in underlying fundamentals ( earnings per share). In other words, I would like to see a dividend payout ratio that stays within a range, rather than a situation where companies grow dividends by paying out a larger and larger portion of the earnings pool. For most companies, there is a need to reinvest a portion of earnings in the business to grow. Anything in excess of that should be distributed back to shareholders, or else risk being wasted by executives on ill-timed acquisitions, corporate jets or projects with poor visibility and sub-par expected risk adjusted returns.
Of course, I also review the trend in dividends per share. Dividends are more stable and dependable than stock prices, which is what makes them an ideal source of income for retirees. I want to focus on companies which can pay and grow dividends no matter where they are in the economic cycle. I review the recent increases in dividends versus the trends over the past decade. A rising dividend indicates a management team that is shareholder focused, which also wants to establish a track record of sharing excess shareholder wealth with the rightful owners of the business. The rising dividend that is based on growing earnings, and coupled with a sustainable payout ratio, while available at an attractive valuation is something I look for in an investment.
Basically in the article I discuss how I like a record of dividend growth, earnings growth and a sustainable dividend payout ratio. If the stock has these traits, I then focus on valuation.
In my conclusion section, I usually link to my article on entry criteria when I call a stock attractively, fully or overvalued. In my article on entry criteria I discuss that I am not willing to pay more than 20 times earnings for a stock. If the company trades at less than 20 times earnings, I would call it attractively valued and call it a day. However, if the stock trades above 20 times earnings I would try to calculate a reasonable price which would make it a good buy on dips. This entry criteria applies to most corporations that pay dividends and are traded on exchanges.
For example, Automated Data Processing (ADP) trades at 27.50 times forward earnings, which is above the price I am willing to pay for it. If it earns $5.18/share, at 20 times earnings, the most I would pay is $104/share. Hence, if I posted an analysis on ADP I would say it is overvalued at 27.50 times earnings, and would buy on dips below $104/share.
If Automated Data Processing (ADP) traded at $90/share, and earned $5/share, I would say it is attractively valued at the moment. For example, in my analysis of Johnson & Johnson (JNJ), I discussed that I thought the stock was attractively valued at the moment.
I link to my entry criteria article, because I want readers to understand how I value company stock.
For a recent dividend stock analysis of Starbucks (SBUX), I assigned an entry price of $48/share at $2.40/share in earnings per share. If you read the article in 12 months and the stock trades at $70 but earns $4/share, you would think it is above fair value and ignore it completely for that reason. However, at $70, the stock would have been attractively valued since the P/E is a reasonable 17.50.
Readers would notice that I do not assign “fair values” to stocks I analyze. I am not going to complicate my screens by using discount rates, forecasting future dividend payments and discounting them back etc.
Instead I use the P/E and yield as mentioned above. However, I do select companies that have raised dividends for at least a decade, and which usually have done so above the rate of inflation. In the end, yield and dividend growth is a balancing act. This should go without saying, but in the valuation criteria I look at P/E ratios in conjunction with looking at earnings growth rates and dividend growth rates. If we select a company with a higher P/E ratio, we would expect a higher growth in earnings and dividend growth. For an equity with lower P/E ratios, we would generally see slower growth but probably a slightly higher yield.
Readers of my dividend growth newsletter are receiving ten dividend ideas per month in their emails. I have these ten companies analyzed in detail, by following the logic outlined in this article. I will post an updated list of the ten dividend growth stocks I will be buying at the end of the month on August 26. The structure of each analysis is similar to the following dividend stock analyses below:
- Clorox (CLX) Dividend Stock Analysis
- Starbucks Dividend Stock Analysis
- TJX Companies (TJX) Dividend Stock Analysis
Thank you for reading!
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- The ten year dividend growth requirement
- My Entry Criteria for Dividend Stocks
- How to retire in 10 years with dividend stocks
- How to become a successful dividend investor