How I Identify & Select Dividend Stock Investments

As a dividend growth investor, I have devised a system that I use to identify and select dividend stock investments since I began investing in September 2017.

Staying true to the mantra of I Prefer Income, which is Rely on Yourself Investing, I have decided to share the process that I use to identify and select dividend stock investments.

It is my hope that sharing this with readers will improve their ability to identify dividend stocks for further research and select dividend stock investments of their own based upon their specific needs and requirements.

The first step that an investor needs to take in order to identify dividend stocks for further research is to determine their investment objectives.

There are some in the dividend investing community that seek high yield that is reasonably safe with dependable dividends and emphasize that over dividend growth, whereas there are others that seek dividend growth over immediate income.

I tend to place somewhere in the middle of the spectrum as evidenced by my portfolio’s yield.

Given that my portfolio’s yield on cost (the annual dividend rate of a security divided by the average cost basis of a position or group of positions) is at 4.61%, it’s too high to purely classify me as a dividend growth investor in my opinion (I believe a yield under two times the S&P 500’s average yield classifies as more of a dividend growth investor).

Simultaneously, the yield of my portfolio doesn’t entirely resemble that of an immediate income investor’s portfolio because I tend to believe a yield over 3 times that of the S&P 500’s classifies a portfolio as immediate income.

The bottom line is that determining whether one is more immediate income oriented or dividend growth or future income oriented is going to be crucial in researching and selecting stocks.

“I Prefer Income filter with criteria options”

Dividend Growth Investment

(Source: I Prefer Income)

If someone is an immediate income investor and doesn’t care to wait 15 years for a company like NextEra Energy (NEE) to rapidly increase its dividend to the point that the yield on cost catches up to the yield on cost of an immediate income investment such as AT&T (I assumed a 10% dividend growth rate on NEE during that time while assuming a 3% DGR for T during that time), then that investor is obviously going to want to use I Prefer Income’s filter feature to narrow down their results to companies that meet whatever their specific yield requirement may be.

Dividend Growth Investment

(Source: I Prefer Income)

As illustrated above, the filter feature of I Prefer Income can prove to be very useful in narrowing down the universe of dividend stocks to a manageable amount for further examination. Narrowing down the number of Dividend Diamond 25+ stocks from 135 to just 7 further supports this fact.

The particular metrics that I used apply to a dividend growth investor. I believe that a 2%+ starting yield and 7%+ earnings growth provides an ample reward for the amount of work that I put into researching investments and occasionally monitoring them.

I also personally prefer to invest in companies with a market cap over $2 billion or mid-cap stocks (market caps $2-$10 billion) because it narrows an investor’s search even further and ensures that they are investing in only the most dominant and well known names that are likely to continue paying dividends for years to come.

Each of the stocks illustrated above are capable of being great investments at the right price, but I Prefer Income’s 10-year median yield metric clearly indicates that Automatic Data Processing (ADP) and NEE are significantly overvalued.

Regardless of whether one is an immediate income investor or a dividend growth investor, the common denominator of both is going to be determining the safety of such a dividend.

If a company’s dividend payout ratios are too high, this could be detrimental in two ways.

First, a company may not be retaining enough capital to fund future growth and future dividend increases.

Secondly, a company also leaves itself with little margin for error or flexibility in the event that a recessionary period leads to a decline in that company’s profits.

Overall, a high payout ratio leaves a company’s dividend more susceptible to being cut and it also reduces the ability for growth.

Determining whether a company’s dividend payout ratio is safe or not depends entirely on the industry.

For midstream master limited partnerships or MLPs, Simply Safe Dividends considers a distributable cash flow ratio or DCF ratio of under 90% to be ideal. DCF is generally computed as a company’s net income + depreciation and amortization – capital expenditures.

For real estate investment trusts or REITS, Simply Safe Dividends generally considers a funds from operations or FFO payout ratio of under 90% to be preferable. FFO is generally computed as net income – interest income + interest expense + depreciation and amortization – gain on asset sales + losses on asset sales.

For most other companies aside from utilities and communications stocks, I generally prefer to see EPS payout ratios in the range of 50% because I believe this strikes a nice balance between rewarding shareholders with immediate income, while also leaving enough capital to reinvest back into the business to support future earnings growth. It also provides a nice buffer for companies to at least maintain their dividend if they ever encounter a temporary bump in the road due to economic conditions or industry headwinds.

I would encourage readers to conduct an analysis of a particular company’s financial statements to determine the payout ratios of such stocks based on their particular industry by visiting the Investor Relations page of the company of interest.

The next consideration for an investor is to determine the earnings or non-GAAP earnings growth potential.

This can be done by examining the earnings growth column in I Prefer Income’s Dividend Diamond 25+, REITS, and Midstream/MLP programs.

Based upon the information in this particular column, company growth estimates, and Yahoo Finance analyst growth estimates (or a comparable site), an investor is able to use this information to determine a realistic growth rate going forward.

I especially like Yahoo Finance’s growth estimates because it includes both the previous 5 year earnings growth rate and estimates for the next 5 years of growth. I also look to company guidance that is outlined in investor presentations to help form an expectation on a realistic earnings growth rate going forward, and look to past results of management and whether they delivered on their past promises.

An investor is able to discern whether the earnings growth of the previous 5 years is likely to repeat or whether it is unlikely to repeat based upon a more subjective judgement of whether a company’s growth fundamentals have improved or deteriorated in the past few years.

The next logical step once an investor has a reasonable estimate for a company’s growth potential going forward is to determine the amount of dividend growth that one requires from their investments.

In my particular case, I am targeting a 4% yield on my investments on average, with the potential for at least 6% dividend growth over the long-term.

An I Prefer Income member can then use the filter once again to eliminate companies that don’t meet their specific dividend growth target.

An immediate income investor would be prudent to generally stick with stocks that maintain dividend growth rates that have historically kept pace with inflation, so a 3-4% dividend growth rate would likely be what an immediate income investor would be looking for out of a potential investment.

Conversely, the goal of dividend growth investing is to target companies that have historically trounced inflation to the point of doubling or tripling inflation, so a 7-8% DGR would be what a pure dividend growth investor would generally be looking for out of a potential investment.

The final consideration from a fundamental standpoint is that of a company’s debt metrics.

It is wise for investors to check out whether a potential investment maintains an investment grade credit rating.

If a company doesn’t possess an investment grade credit rating from the major rating agencies (i.e. S&P and Moody’s), this is often indicative of a company that is on shaky ground from a balance sheet standpoint or a company that is in a deteriorating industry, whose likelihood of repaying its liabilities is diminishing as well.

Fortunately, I Prefer Income also includes debt metrics such as debt to EBITDA and debt to equity and the ranking feature allows an investor to compare companies within a particular industry side by side, which helps to provide a clear picture of how a company’s balance sheet stacks up against its peers.

Although debt to equity metrics can vary significantly from one industry to the next, I’ve provided what I and Simply Safe Dividends consider to be desirable metrics for each industry:

Consumer Staples: Below 0.65
Telecoms, Utilities, MLPs: Below 0.60
REITs & Tobacco: Below 0.50
Most Other Industries: Below 0.40.
Energy: Below 0.30
Pharmaceuticals: Below 0.20

By examining whether a company possesses an investment grade credit rating and comparing it to its closest peers within its sub-industry, investors should be able to arrive at a conclusion on whether a company’s balance sheet could spell trouble for the safety of a company’s dividend, as well as its growth potential going forward.

The last notable consideration for an investor is to examine the valuation aspect of an investment.

Another common theme that applies to both immediate income investors and dividend growth investors is that valuation matters tremendously.

Take for instance, this example that is briefly discussed below:

Let’s say that a company trading at fair value grows its earnings at 7% a year for 10 years, with a 3% dividend yield, and it’s trading at fair value based upon its 10 year median dividend yield as provided by I Prefer Income’s programs (so no valuation multiple expansion or contraction). In this case, we’d expect annual total returns of 10% (7% earnings growth + 3% dividend yield). Investor A invests $10,000 at this entry point and doesn’t reinvest dividends.

Now let’s say that same company only offers a 2% dividend yield and investor B decides to purchase shares. This would imply that the company is trading at a 50% premium to fair value (fair value divided by current stock price is how that is calculated).

A practical example of what this looks like in real life rather than in theory could be a stock that pays an annual dividend/share of $3.

Investor A would be paying $100/share ($3 dividend/3% yield or 0.03), whereas investor B would be paying $150/share ($3 dividend/2% yield or 0.02).

Simply put, investor A is receiving a higher starting yield without the risk of downside over the long-term while investor B is receiving a lower starting yield and assuming risk of downside in the form of multiple contraction over the long-term.

Fundamental analysis of stocks is reliant upon the notion that while stock prices tend to fluctuate greatly on an annual, quarterly, or monthly basis and they can reach a state of overvaluation or undervaluation, stocks tend to revert to their fair value over time, which is a happy medium between being overvalued and undervalued.

A fair value greater than the stock price indicates a discount to fair value and upside in the form of valuation multiple expansion, whereas a fair value lower than the stock price indicates a premium to fair value and downside in the form of valuation multiple contraction.

Because companies typically revert to their fair value over the long term, this would mean that a reversion to fair value would result in an average annual reduction in returns of ~3.9% over the next decade (calculated by dividing the 2% yield by 3% and arriving at 0.667, and by plugging in 0.961 into our calculator to the 10th power, we arrive at the 0.667 figure). This would lead to annual total returns of 5.1%. Investor B invests $10,000 at this entry point and doesn’t reinvest dividends.

Over the course of those 10 years, investor A turns their $10,000 investment into ~$25,937 (1.10 to the 10th power times the $10,000 investment) while investor B only turns their $1,000 into ~$16,445 (1.051 to the 10th power times the $10,000 investment).

The striking part is this is just one investment over the course of 10 years and there is already a material difference between what the two initial investments became. When you compound this over a couple more decades, the results inevitably become even more profound.

Concluding Thoughts:

The most important starting point for an investor to begin their journey of independent research is to first determine what their investment objectives are and whether they are seeking immediate income, dividend growth, or some combination of the two because this will guide what investments they will eventually research.

Once an investor makes this determination for themselves, the fundamentals of a company must be examined (i.e. dividend safety, earnings growth, dividend growth, and debt metrics) in order to eventually select stocks suitable for investment.

The final consideration of valuation is arguably just as important as the prior investment considerations because buying a great company at random wouldn’t always lead to desirable investment results.

When an investor pays a significant premium for a stock, they are not only losing out on starting yield, but they will assuredly experience valuation multiple contraction as a company reverts to its historical fair value. This explains how an investment in a particular stock is lucrative at or below fair value, but can destroy wealth or create very little wealth over the long-term at a bubble-like price.

Thanks for reading and I hope that you found value in the blog post. Please let me know if there are any other considerations that I may have missed that you like to include in your research and selection process of dividend investments.

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