More investors are pivoting toward dividend stocks to produce income for their portfolios. And that’s no surprise. With near-zero interest rates, fixed income securities like bonds just don’t cut it anymore. But, success with dividend investing is far from being a “set it and forget it” process. Like with value or growth investing, it pays to use stock valuation methods in your selection process.
How so? You can’t depend on stock dividend income like you would bond interest income. Companies have to make interest payments. But dividend payouts? They’re optional.
If a company needs cash, it can easily cut or suspend the dividend. And this year, that’s been commonplace. Former high-yield stock Ford (NYSE:F) suspended its dividend due to novel coronavirus headwinds. Hard-hit bank Wells Fargo (NYSE:WFC) slashed its fat dividend as well.
So what’s the best game plan? Instead of chasing the highest yield, your focus should be on dividend growth. But how do you screen for dividend growth plays? By using these three stock valuation metrics, all of which can help you separate the wheat from the chaff:
- 10-year growth rate
- Payout ratio
- Yield on cost
So, let’s dive in, and see how these metrics can help you find better opportunities:
Dividend Stock Valuation Methods: 10-Year Growth Rate
It’s temping to focus on only the highest-yielding dividend plays out there. But, that may be a short-sided approach. Stocks paying moderate yields, but with a track record of rising payouts, may be the best place to fish.
How do you screen for these opportunities? A great metric to use is the 10-year growth rate. That’s the dividend’s annualized growth over the past decade.
CLX stock is what’s known as a “dividend aristocrat.” These are blue stocks that have raised dividend payouts for at least 25 consecutive years. For decades, investors who have bought a basket of these securities have seen solid returns.
Granted, dividend aristocrats have slightly under performed the S&P 500 (NYSEARCA:SPY) over the past decade. But, with lower volatility, and a tendency to outperform during recessionary environments, dividend aristocrats are a great option for those looking for dividend investors.
Another metric to use when searching for growing dividend stocks is the payout ratio. What’s that? It’s the stock’s forward dividend per share, divided by its forward earnings-per-share (EPS).
For example, Kimberly-Clark’s (NYSE:KMB) annual forward dividend payout is $4.28 per share. Since its forward EPS is $7.69 per share, that means its payout ratio is currently around 55.7%.
As InvestorPlace’s Mark Hake wrote earlier this year, a good rule of thumb is to focus on stocks with payout ratios of 60% or below. Why? This payout level leaves enough breathing room for the underlying company. That is to say, enough money left to buy back shares, increase the dividend, reinvest in the business, or anything else that could move the needle.
The example mentioned above isn’t the only solid dividend play with a reasonable payout ratio. General Mills (NYSE:GIS) is another one that comes to mind. Its payout ratio is similar to the example above (56.2%).
At this level, GIS is rewarding shareholders with a reasonable yield (3.3%). But, at the same time, leaving enough cash in its coffers to help grow the business, and in turn, the dividend payout. As seen from the stock’s 10-year growth rate (8.09%), that seems to be the case here.
To screen for dividend stocks with plenty of runway, the payout ratio is one of the metrics out there.
This stock valuation metric is similar to the payout ratio. But, instead of focusing on just the level of dividends relative to income, it also accounts for the company’s balance sheet strength.
How? By measuring long-term debt relative to shareholder’s equity. Not only can this signal whether a stock has room to grow its dividend. It can also measure the chances of a dividend cut or suspension down the road.
For example, AT&T (NYSE:T) has been pushing things to the limit with its 7.3% dividend yield. Due to its 2010s acquisition spree, “Ma Bell” has a bloated balance sheet. Its debt-to-equity ratio now stands at 0.79. And, as this commentator noted, the risk of a dividend cut remains high.
And not only due to the debt. Competitive risks could also impact performance in the coming years. And, if earnings start to dip, while debt remains high, somethings got to give. And chances are that will be the current fat payout.
While not all debt-burdened companies are bound to cut their dividends, this metric can help you avoid these high-yield, but high-risk, dividend plays.
On the date of publication, Thomas Niel did not (either directly or indirectly) hold any positions in the securities mentioned in this article.
Thomas Niel, contributor to InvestorPlace, has written single stock analysis since 2016.