I have a simple process for evaluating companies. I focus on several key factors, which tell me whether a company is worth putting on my list for further research or not at all.
1. In general, I look for companies that have managed to increase dividends for several years in a row. At least 10 consecutive annual dividend increases is a minimum requirement, as it signals a business model that has produced excess cashflows through a typical boom/bust economic cycle.
This narrows down my population a little bit, to a more manageable list of about 500 companies in the US as of the beginning of 2025. There are several hundred more of those companies abroad.
2. Second, I look for growth in earnings per share over the past decade. Rising earnings per share are the fuel behind future dividend growth. In other words, without growth in earnings per share, future dividend growth will end at some point. Note that for certain entities such as REITs for example, one needs to look for more unique metrics such as Funds from Operations (FFO).
In general, I like to see rising earnings per share over the past ten and five years. I realize that EPS will not go up in a straight up line all the time, and some fluctuations may occur. These days, we have one-time items hitting the earnings, which can temporarily sway things in either direction. But for as long as these one-time items are not always occuring each year, we should be good to go. Also note, it is very likely I should be using Free Cash Flow Per Share instead of Earnings Per Share. In general, their long-term growth should be identical relatively speaking. For the purposes of this conversation, I would use those interchangeably.
3. Third, I look for growth in dividends per share over the past decade. I like to look at most recent dividend increase, along with historical growth in dividends per share. This exercise helps me identify relatively quickly whether dividend growth is accelerating or decelerating. I understand that dividend growth will fluctuate from year to year or period to period. However, I do subscribe to the signaling theory, which states that management provides us signals about how the business is doing, by setting dividend growth rates. In other words, if dividend increases starts becoming anemic all of a sudden, this means that most likely business conditions are softening. Perhaps the previously believed wide moat firm may be seeing its moat eroding from changes. If the dividend growth stays at a fairly steady clip, then it's likely business as usual, for as long as earnings are also growing at a steady clip, and the payout ratio is not rising too much and too fast.
A rapid increase in dividends per share may signal confidence in the business. However, it may also be signaling that management is bluffing too in my opinion. I've witnessed very high dividend raises by companies in the past, notably CenturyTel about a decade or so ago and UPS around the time of Covid. These companies fortunes turned south afterwards. On the other hand, for some companeis like Dick's Sporting Goods, a high raise in dividends was a precursor to more good times ahead.
4. Fourth, I look for trends in the dividend payout ratio. In general, I prefer a flat dividend payout ratio that is below 60%. A lower payout ratio provides a good margin of safety than a higher payout ratio. That being said, there are several other factors to consider. For a company in the initial phase of dividend growth, the payout ratio would be going up for a while, as dividend growth exceeds earnings growth, up to a point. For many companies in certain industries, such as tobacco or for REITs, the payout ratio is going to be high, which is why the analysis needs to focus on stability of underlying cashflows/earnings. Dependable and less cyclical cashflows can support that high payout ratio, but it is still a risk of unknowns as cuts can be more likely in higher payout ratio companies than lower payout ratio ones.
For most companies in the sweet spot, a good range in the payout ratio is probably a good bet.
That being said, I try to look at trends in earnings per share, dividend growth and payout ratio together, rather than in a vacuum. There are relations between these indicators that need to be looked together to gain a fuller picture of what is going on.
In general I also look at valuation, but this is a fun piece that takes things even further. Also, it's great to look at it after you've looked at stability of cashflows, their growth, payout ratios and the signaling power of the dividend. Or rather, taken all into consideration. Then one needs to take into consideration interest rates, the cyclicality of the business, growth and growth expectations and then determine whether this valuation range is reasonable or not. Valuation is part art, part science.
In terms of a somewhat succint summary, it is good to think in terms of trade-offs in the full picture. The expected returns formula I use really summarizes things neatly, and makes you think about how changes in the different variables impact overall results over a given time period.
