Analyzing, rating and selecting dividend stocks can be difficult and time-consuming. The question is how do you prevent mistakes when you are searching for attractive dividend stocks?
Our Smart Dividend Score (SDS) system is designed to help dividend investors, to identify strong companies with a sustainable dividend and avoid companies that could be riskier to invest in.
The Smart Dividend Score System takes into account several fundamental and price-performance metrics that affect a company’s ability to continue paying dividends and its overall return.
Some of the criteria analyze are:
- Business model and growth perspective
- Dividend history and dividend growth
- Dividend Yield
- Payout ratios
- Cash flow
- Debt ratio
- Price/earnings and enterprise value/EBITDA ratios
- Recession performance
- Geometric annual performance and loss ratio
The SDS scores range from 0 to 100. Of course, there are no guarantees when it comes to investing, but if a dividend stock scores over 60, it is an indication that the quality and the sustainability of the dividend are probably okay.
By comparing companies’ Dividend Scores, you can easier select quality dividend stocks and improve your chances of generating dividend income and preserving capital in the long run.
Business model and growth perspective
A sustainable business model is essential to maintain future dividends and dividend growth. A sustainable business model means that companies are financially sound, have a competitive advantage and have business models that are more resistant to fluctuations in the economic cycle.
The term economic moat is often used in this context. The concept of the economic moat comes from Warren Buffett and refers to a company’s ability to maintain a competitive advantage over its rivals and thus protect its long-term profitability and market share. In addition, the companies must be able to adapt to changing market conditions and also deliver added value in the years to come.
Long-term dividend investors should look for companies that have a “wide moat”. There are several factors that make a company a Wide-Moat stock, things to look for are:
- A strong brand name recognition or patents
- High switching costs to a competitor
- Better financial performance compared to competitors
- The dominance of a Single Product, like the iPhone
- A cost advantage that competitors cannot replicate
Companies like Walmart, AbbVie, Roche, Apple, and Coca Cola are excellent “wide moat” examples.
Dividend history and dividend growth
It is attractive to select companies that can maintain or even increase their dividend payments even in bad times. This is an indication that the company has a strong market position in a stable business that performs well throughout the economic cycle. It is also a sign that management is quite confident in paying (and increasing) its dividend going forward.
Some companies like Realty Income (O) or Nestle (https://www.nestle.com/investors/individual-shareholders/dividends) are even “advertising” with the “number of consecutive years of dividend increases” towards dividend investors. Keep in mind that dividend policy isn’t an obligation, dividends can be cut at any time.
The chance that a dividend aristocrat (a company that has continuously raised the dividend for 25 consecutive years) suddenly cuts its dividend payout is much smaller than a company that already had to make the necessary reductions in the past.
The S&P Dividend Aristocrats Index has outperformed the S&P 500 over the past decade. According to S&P, Dividend Aristocrats generated an annualized return of 13.70% over the past 10 years, easily beating the market’s 12.40% rate. Important to note is that over this period, dividends accounted for 31% of the market’s total return.
The dividend yield is another metric to look at when analyzing dividend stocks. A high dividend yield does not automatically mean that it is an attractive stock to invest in. Related elements to take into consideration are special dividends, buyback programs, and pay-out ratio.
The payout ratio will tell you how much of earnings per share (EPS) is used to pay the company’s dividend. Therefore, if a company posted an EPS of $1.00 and distributes a dividend of $.45 per share, its payout ratio is at 45%. A good payout ratio is usually below 80-85%.
However, it is a lot more complicated than this. Payout ratios can differ per sector and the buyback program will influence the dividend quality.
Stable cash flow
Without stable cash flow, it is almost impossible to maintain the dividend in times of a downturn. Cash from operations and free cash flow are 2 important metrics for a dividend stock. Cash from operations is seen as “how much the company generated throughout its business operations,” and must, therefore, show a stable pattern for time.
The free cash flow is defined as the amount of cash generated by the company that is available for distribution among its security. So, enabling the company to pay dividends.
Ideally, the company manages to grow both cash flows in both good and bad times. This indicates that the company has a strong market position in a stable business. There will be a good chance that the dividend will continue to be increased in subsequent years.
Low debt ratio
Companies with a low debt ratio have the option of maintaining or even increasing the dividend even during recessions. The (net) debt-to-EBITDA ratio is a great metric to include. Also, for comparing a company’s debt with others in the same industry.
For dividend stocks, we prefer a debt-to-EBITDA ratio below 1.5. A debt-to-EBITDA ratio between 1.5 and 3 should not be a problem for companies with stable cash flows, but it does leave less room for extras for shareholders. A debt-to-EBITDA ratio above the 4-5 range is typically considered high and puts the dividend payout at risk.
Investors assume that quality stocks can withstand an economic downturn better than others and see exposure to quality stock as a way to reduce risk. Quality stocks do often come with a higher price tag.
However, this does not mean that we are willing to purchase a quality dividend stock at any price. There are many ways to calculate valuations, such as the Dividend discount model (DDM), the Gordon Growth Model (GGM) or comparing the 5 years average dividend yield with the current dividend yield.
To determine whether the company is attractively valued, we focus on two metrics the price/earnings ratio and enterprise value (EV) / EBITDA ratio.
These two metrics can also be used for comparing a company’s valuations with others in the same sector.
Ideally, the EV/EBITDA and P/E of a share are lower than those of peers in the sector, but with higher expected growth. Since “quality comes at a price”, the dividend shares selected could score below average on this aspect.
A quick assessment of the current valuation can be done by looking at the past 5-10 years of PE history and combine it with the forward P/E ratio. This simple valuation method will tell you how the market values a company currently. As the stock 3M is trading at a forward P/E of nearly 19, you can tell the market valuation is currently on-par with historical averages.
It is important to analyze the performance of a dividend stock during a recession period. We analyze each dividend stock by looking at their earnings, dividends, maximum draw down (MDD) and stock price performance during the 2007-2009 financial crisis. It is easier to stick to your investment plan by keeping emotions out. Preferably, a company is able to increase earnings and dividends during a recession. This could give long-term investors some peace of mind.
Important aspects of dividend investing are the compounding effect of dividend income and the fact that dividends are contributing for one-third to the total return.
Excluding dividends, a one-dollar investment made using the S&P 500 on Jan. 1, 1930, would have grown to $115 by the end of December 2018. During the same period, the same investment with dividends reinvested would have yielded $3,626.
Still, the price-performance of a dividend stock is important for long-term investors. In our Dividend Score System, we incorporate two premium data-elements, the 10-years geometric annual performance and loss ratio.
Quality Dividend stocks with a safe dividend
The above-mentioned metrics will help dividend investors, to identify quality dividend stocks with a sustainable dividend and improve your chances of generating dividend income and preserving capital in the long run.