Selecting Dividend Stocks

In this article, I will share my methodology of selecting a dividend stock, and in the process address some of the more common criticisms directed at dividend investors. The principles utilized here are more suitable for dividend stocks, not REITs, which I will address in a separate post. I am a strong proponent of the dividend growth portfolio.

Selecting stocks based solely on their dividend yields is setting yourself up for falling into a dividend trap. Companies that are experiencing shrinking revenue and profits are commonly found in the high dividend yield category, and should be avoided at all cost. Another category involves companies that are highly leveraged and paying out unsustainable dividends. Falling into the dividend trap will result in capital losses in the long run, which could very well more than offset the large dividends received.

Growth matters. In general, I avoid companies with poor prospects in terms of revenue and profit growth. If a company is reporting flat or even negative revenue and profit growth, you would likely be better off buying the company's bonds. Buying a cheap and high yielding dividend stock which is expected to fare poorly is setting yourself up for a dividend trap of a stock that will keep falling as earnings contract. Any dividends collected will likely be offset by the gradual erosion of share price in the long run, making the argument for holding the company's bond more compelling. Of course, this assumes that the company will not default on its debt payments.

How does one forecast a company's growth rate? This usually requires some research into the industry and the company's position and developing a view. For example, a bank's revenue and profits usually tracks loans growth, which in turn is a function of GDP growth. If one expects GDP growth to accelerate, then the bank's revenue and profit can be expected to grow at a faster rate. Developing a fundamental understanding of the industry and company itself is vital in this aspect. In companies involved in stable and relatively matured industries such as banks, utilities and telecommunication companies, their growth rates are fairly predictable. Others such as commodity producers have very unpredictable growth rates, and generally make poor candidates for a dividend growth portfolio.

Dividend Discount Model. My optimal dividend growth portfolio is one that generates both dividends and capital gains. Allow me to share my methods in selecting candidates for my portfolio. I start off with the Dividend Discount Model, which basically states that the current share price is a sum of all dividend payments that are expected to be received, discounted to the present. This model is appropriate for the purpose of our discussion, given that we view a dividend stock as the sum of all its dividend payments. The variables represent the following: P-stock price, D1-dividend per share for the next year, r-return on equity and g-profit growth rate. While g is typically used to represent dividend growth rate, I prefer to use the expected profit growth rate since I equate long term dividend growth with that of profit growth.

The Dividend Discount Model can be rearranged to describe the r-return on equity. The equation below expresses total return (in percentage terms) as equal to dividend yield (D1/P) plus profit growth.Since I have stated repeatedly that the stock price tracks profit growth in the long run, I implicitly assume that the profit growth rate will translate into equivalent capital gains e.g. a stock with a 5% profit growth rate will appreciate by 5% annually. Of course, stocks rarely behave as such in reality, but I am certain that most readers will agree that profit growth generally leads to capital gains.

Essentially, this model functions as my basis when selecting dividend stocks. As a general guideline, I use 10% as my personal hurdle. My minimum thresholds for dividend yield is roughly 4% and profit growth, 1%. That means that if I'm buying a stock with 4% yield, I would require a long term growth potential of at least 6%. Setting a minimum growth threshold of 1% means that I will generally avoid a company that is experiencing flat or contracting dividends per share/unit. The table below shows the outcome of using this model in accepting/rejecting stocks.

This model is a useful initial screen when sorting through stocks or even REITs, though further fundamental analysis will be required to confirm this pick. It also implicitly captures a stock or REITs valuations, since a rising share price will result in falling dividend yield (dividend yield = dividends per share/current stock price). If a stock's price has risen to the point where its dividend yield has fallen below my hurdle level of 4%, I may consider it as a trigger to take profit on the stock.

Price-to-Earnings Ratio link to Dividend Yield. Looking at a stock's dividend yield, is it sustainable? What then is a sustainable dividend yield? These are questions that every dividend investor needs to be able to answer. A simple and quick way to identity the maximum sustainable dividend yield is to check the stock's Price-to-Earnings (PE) ratio. Taking the inverse of the PE ratio, that is dividing the stock's Earnings-Per-Share (EPS) by the stock price, gives us the earning yield.

Consider a company with a PE ratio of 20x. Its earning yield is 5% (1/20), which is to say that purchasing the stock at its current price gives you a profit yield of 5%. If the company decides to declare a dividend equal to 100% of its profits, the dividend yield of the share is equal to exactly 5%. If the company chooses to pay out 40% of its profits, the dividend yield works out to 2% (40% X 5%). However, if that company with a PE of 20x pays a dividend yield above 5%, this is unsustainable in the long run as it is paying out more than it earns. Even a 100% dividend payout ratio is not healthy, as the company is not retaining any profits, limiting its ability to grow.

Conversely, if a company trading at a PE of 8x (earnings yield of 12.5%) has a dividend yield of 5%, the company has plenty of room to raise its dividend payout. Hence, an expensive stock (high PE ratio) with a relatively high dividend yield is unlikely to be able to sustain that yield in the long run. I prefer companies that pay out about 50% of their profits, as it strikes a balance between satisfying stockholders and accumulating profits to fund future growth.



What does the payout ratio tell us? As a dividend investor, it gives us a clue as to how much headroom the company has in raising dividends. If the ratio is less than 50%, the company has plenty of room to increase the dividend yield. In the table above, Stock 1 which presently yields 5.0%, could potentially raise its dividends substantially because its dividend payout ratio is only 40% at present. Contrast this with the other stocks with higher or similar dividend yields but a much higher payout ratio.  If Stock 1 has a decent expected growth rate, then it is likely an undervalued gem.

This guide is only intended to open the investor's mind to looking at dividend stocks using a simple  but effective framework. However, further fundamental analysis is required to confirm the stocks that are filtered out by this screen. 

Summary
Dividend investors who focus on dividend yield only and ignore a stock's valuations and growth outlook, do so at their peril. Dividend yields are a function of the stock's PE and dividend payout ratio and it is crucial to understand the relationship between these variables. Profit growth is the ultimate driver of capital gains of all stocks, including dividend stocks, in the long run. I am a firm believer that using these strategies, one will be able to not just generate a stable and growing income stream, but enjoy steady capital gains in the long run.