How I analyze dividend growth stocks
The answer to this question is not a simple one. I’m going to be as thorough as possible. A complete stock analysis is made in two parts. First there is a qualitative and subjective part of analyzing the future prospects of a company. Second, there is a rational and quantitative analysis to be made.
Making a list of criteria to select stocks is a little like making a list of criteria to find love. You’ll have to identify the core ones that you don’t want to transgress, and those on which you can be less selective. Nothing is ever perfect in life!
My 10 commandments :
1. I will put the same effort in analyzing a prospect company in which I’d like to buy a couple shares than if I’d want to buy the whole company!
Shares are not lottery tickets. They are part ownership of businesses with employees, products, customers. People often tend to forget that.
2. I will only buy shares in simple business that I can understand and avoid companies who have to resolve complex problems to make money.
That way, it will be easier to evaluate future prospects and the value of the company I’m interested in.
3. I will only buy shares in companies in which I can “see” future growth.
If I’m able to project myself in the future and still see that company exist in 5, 10 or even 25 years, then I might consider investing in that company. If not, I’ll pass. This should exclude Facebook… I really have no clue about the future of this company… Is it a fad? I don’t have a Facebook account myself…
Good luck to me!!! I’d like every companies in the world to be managed by a dividend paying Warren Buffett, but unfortunately, it won’t happen. Many CEOs are destroying shareholders’ equity in stupid acquisitions (which will eventually need restructuring), in share buybacks at times when the stock price is historically high instead of historically low to cover the fact that they are unable to find growth (give me a dividend instead, I’ll invest the money at better places) and in dis-gracious stock options for the high management (they often have a share buyback program in order to “cover” the stock options). Why in the world do we have to pay CEOs 1000 times more than a single employee??? Most well-established companies are already well rode cash-machine. Do we really need to pay someone 23 millions per year to manage such companies? Just give us dividends!
5. I will only buy when the price is fair or undervalued vs the intrinsic value of the underlying business
As Benjamin Graham said : “Price is what you pay. Value is what you get”. By buying at low prices, it will provide me with a margin of safety to protect my hard-earned capital. And since that for calculating the fair value of a company you’ll need a very predictive business, commandments #2 and #3 are very important to follow.
6. I will invest for the long-term
My plan is to retire over dividend and other passive sources of income. By definition, dividend growth takes time. My horizon is long-term! I will avoid trying to anticipate short-term price movements for my dividend portfolio. I might though risk 5% of my money on volatile or growth stocks on which I can get nice returns with the use of technical analysis. Technical analysis will also serves me to find a good timing to enter the stock. But, in general, as long as the fundamentals remain the same, I will hold my stocks.
Warren Buffett already said that the best time to hold a great stock is forever…
Read : until it is not a great stock anymore.
7. I will mostly invest in the bests of the bests – those having a wide moat over their competitors
Warren Buffett has coined the term “wide moat“. He compares equities as small castles. The larger the outside moat, the harder it is for barbarians to pass the gate! These companies have a tendency to outperform their peers over the long-term. We can generally see that by the return on equity they have (ROE) which is consistently above their competitors.
8. I will pick stock in companies who use low or no leverage to obtain growth
In an ideal world, I would prefer investing in companies able to generate growth with their own cash-flow. If a company always need to emit new stocks, to make acquisitions or to borrow a lot of cash, then there might be a problem.
9. Most if not all of the times, I will pick dividend growth stocks!
Dividend paying stocks are generally less volatile than the one who don’t pay a dividend. Since we have data on the stock market, dividend paying stocks have shown that they outperform by a lot their peers over the long-term. It is harder to have creative accounting when you have to deliver cold hard cash to your shareholders every quarter.
Most of the time I will prefer stocks with a long dividend paying history. I prefer these because no CEO would like to be remembered as the CEO who has cut the dividend… But, some stocks like Berkshire Hathaway (BRK-B), Warren Buffett’s company, may find a way in my portfolio one day even if it does not pay a dividend.
In the end, dividend growth investing is a nice way of creating wealth. But, a couple growth stocks could help improve the total return. And total return remains important in the end because what you get every year, is a percentage of the total market value of your capital.
10. Finally, I will not over-diversify too much my portfolio
I have limited time to invest in managing my portfolio. I also have no problems in keeping a lot of cash in my trading account for a while until I get the diamond in the rock. Because being too anxious at buying stocks can result in great losses or under-performance. The greatest company bought at the worst price will be an investment with a bad return on invested capital. The long-term market return of the S&P500 is somewhere around 11%. I’d like to reach that kind of return because if I don’t, then I kind of lose my time since an index fund passive investment strategy could give me that kind of return…
If I think an investment is really worth to be done, then I might put a lot of my hard-earned money into it at once. I’m still not a 100% sure about how many stocks I will hold – certainly not hundreds – but I’ll probably hold between 30-50 stocks over time.
All these stocks will become “workers” in my cash compounding machine and I will get all their paychecks! If one of my “workers” starts having problem and don’t receive a paycheck for a while, then knowing that I still have 49 other “workers” earning growing paychecks kind of protects me from having to readjust my way of living at retirement.
Concentration might give a better total return, but gives less income protection. In the end, nothing is free and security always has a price!
Now that all these commandments are carved in the rock, lets see how to do it in technicality.
STEP 1 : Identify the potential growth trees in the forest!
Thousands and thousands of companies have their stock trading on the market. If like me you don’t have enough time to go through every one of them, be reassured that there are shortcuts you can take to shorten the list. I generally rely on two things. First, wonderful dividend stock’s lists. Second, screeners.
While accumulating savings for my next purchase, my work is to build a prospect list of great dividend growth stocks and estimate their fair value. These stocks will be listed on my watch-list’s page.
S&P 500 dividend aristocrats constituents these companies have increased their dividends year after year for over 25 years!!
While you probably won’t find grow stocks that are going to skyrocket in these lists, it makes a good starting point to start a dividend growth portfolio!
For other (tons) great lists and resources, visit my Best resources for the dividend growth investor page!
Screeners are invaluable tools! Simply input your minimal requirements and press search to get a list that matches your criteria. While they are more focused on technical analysis, they can help the dividend growth investor find interesting dividend growth stocks very fast.
Finviz – great screener that you can use both to find stocks based on their fundamentals, but also based on technical analysis. This could be helpful to search for stocks at their 52 weeks low that meet your dividend growth requirements. It is only limited to stocks listed in US exchanges.
TMX screener – if you plan on investing in Canadian stocks, TMX money offers a screener. While not as extensive as Finviz, it at least can help you reduce your researches.
I’m not a big fan of this one, but hey… It’s free and sometimes it can help.
Step #2 Is the business model easy to understand?
To understand how the business makes profit is of first importance before deciding to invest your savings. If you don’t understand the business, then pass. It’s okay not to understand every existing business models. But, it’s not okay to invest if you don’t. Warren Buffett would tell you to stay in your circle of competence.
Read financial analysis from pros and seek to figure out the money cycle. Do they need to invest a lot in R&D to make a profit? If a company always need to resolve complex problems to make a profit, usually these companies don’t have a great return on equity and need to make a lot of acquisitions to make sure that they are not outsmarted by a competitor. Do the company need a lot of leverage to make a profit? Is it only relying on two or three big customers?
To be able to evaluate with a certain precision the potential growth, sustainability of a dividend and fair price value, one must pick highly predictable businesses.
This is one of the reason why Warren Buffett has always been interested by companies who have tons of customers buying again and again and again and great brands.
Step #3 Is it the best company in its industry?
Warren Buffett has coined the expression “wide moat” to describe the competitive advantage of a company.
While many companies can have great future prospects, some earn a consistently better return on equity than their peer competitors. Over the long run, all that extra cash can give that company an edge on its peer that should, in the end, translate in a better return and security for you stockholder.
So, most of the time, if the price is fair or undervalued, I will invest in the bests of the bests.
Think about a football team. Your greatest QB has decided to retire. If your goal is to win the SuperBowl, will you try to replace him with a good QB with good potential or with the greatest QB with the greatest realizations?
The problem I might have is that these company’s share usually sell for a premium. And, one of my rule is to make sure I have a margin of safety included in my purchase price. Dips in the market can then serve as good entry points to buy shares in these companies.
But, Warren Buffett has learned over time, and said it many times, that it’s preferable to pay the fair value for a great company than a great price for a so-so company.
What gives a wide moat? Read Morningstar’s definition of a wide economic moat.
How to identify wide moat stocks
I will use two methods to identify wide moat stocks.
First, I can rely on Morninstar’s wide moat rating. In my brokerage account, I have access to Morningstar’s stock analysis. They give a moat rating on these reports.
Generally, I’ll focus on companies having a ROE over 20%. But, you always have to compare the ROE with the industry. Different industries might have different “normal” ROE. As long as the ROE is consistently above the competitors and stable or growing, then this suggests that the company has a competitive advantage. It is not always true, but it is most of the time.
To perform this analysis, I need the last year ROE, 5 years average ROE, 10 years average ROE and the exact same information for the entire industry.
Return on equity can vary widely from year to year. It’s the reason why I try to “smooth” things out by taking averages.
Finding the data can be tricky sometimes. Morningstar gives a lot of information about stocks. You should usually be able to find the information there for free. Here’s a link to Morningstar to get the Key Ratios for McDonald’s. Just change the stock symbol to get the information for another stock.
In case, here’s how to calculate it manually :
Return on equity = net income / shareholder’s equity
When you have confirmed the quantitative part of this analysis, you have to ask yourself if there is something that could change that over the next couple of years? Are there barbarians at the gates? Do they have the ability to make the company lose its wide moat?
Think about Sears and Kodak, once great companies…
Step #4 Revenue and earning growth
I will diversify my portfolio around these two principles. If the yield on purchase is low (2%-4%), I will search for a big dividend growth (8-10%). If the yield on purchase is higher (>4%), then I can accept a little slower growth 3-7%. The higher the dividend, the lower the dividend growth can be, as long as it consistently beats inflation, plus a premium. High growth of 15-20% or more are great, but will need the revenue and earning to eventually grow at the same pace if we want that dividend growth rate to be sustainable.
Higher yield slower divdend growth or lower yield higher dividend growth?
Here’s a little example to explain why I’m flexible on dividend growth rate. Let’s say that in case 1 you invest 100$ on year 0 and get a 2,5% dividend the first year. Then, you get an 8% dividend growth every year. In case 2, you get a 5% dividend return on your 100$ investment. But, every year, your dividend only increase at a rate of 4%.
|Year||Scenario 1||Scenario 2|
As you can see, Case 1 will beat case 2 over time and throw back more dividend cash. But, it’s going to take a full 20 years before it beats Case 2 and after 30 years, it will have throwed back only 3,21$ more. But, over these 20 first years, Case 2 would have provided you with 34,49$ of extra cash to reinvest in your portfolio during the accumulation phase and like all dividend growth investors, I know that reinvesting that cash gives a very important snowball effect.
Now, this is for 1 share bought at 100$. If you had 100 shares, it would have been an extra 3449$ to reinvest in your portfolio over these 20 years!!! Not bad!
I want to retire young
Since my goal is to retire sooner than later and since I’m already of a venerable age, a mix of both high yielding stocks with less year to year growth and low yielding with higher year to year growth might be a good thing for me as I could get more cash flow to reinvest in my dividend portfolio while I am in my accumulation phase while having a decent dividend growth for the future.
For sure, I could have continued the compounded interest table and you could have seen that after 40 years, Case 1 would yield you a full 50,29$ vs case 2 23,08$, or twice as much. But in 40 years from now, I might not care a lot about this anymore… I’ll be damned too old!
Also, I could have calculated the return with a DRIP, but I didn’t. The example was meant to show that you could get more cash every year for a long time before getting beaten if you select stocks with higher initial yield and lower dividend growth. And most investors know that predicting what a company will be doing 5 years from now is already difficult. Now, imagine 30 or 40 years from now???!!! So, don’t chase high yield, but don’t get fully invested in low yielders either just because you expect the dividend growth to be massive. The dividend growth could be reduced. And that’s why you must make sure that the dividend growth is sustainable.
Okay, lets recap. For a dividend to be sustainable, we have to see an increase in earnings that should average the same growth. So for a 8% growing dividend per share, you should see a 8% growing earnings per share (EPS). And for the earning per share to grow at that pace, you should also see the revenue per share grow at the same rate. I want to see Earnings Per Share (EPS) growth above 8%, but it’s also important to look at revenue per share growth.
All of this is linked! For sure, EPS could grow faster than revenue per share. This would generally mean that the company has found ways to be more efficient, which is good. But, there’s a limit at how efficient one can be. One day or another, you’ll have to see revenue per share increase at the same pace than earnings and dividends per share.
They know how to trick the investors!
Businesses have a lot of tricks to make you believe the dividend will healthily grow over time at an unbelievable rate. That’s why it’s important to understand the relation between revenue per share, earning per share and dividend per share.
Let’s see another example. Let’s say the net income of a company stays flat. But, earnings per share have increased by 4%. What does it mean? It means they have found ways to be more efficient? Yeah maybe. But, it could also means that the company has bought back shares, thus increasing the earnings per share while the total income remained flat. So this means you have to check the total figures and the figures per share.
Now, let’s say the revenue stays flat, the earnings per share stays flat, but the dividend growth is 10%. How could that have happened? Simply because they increased the payout ratio!
If a company has an earning per share of 10$ and a dividend payout ratio of 30%, then the stockholder will receive 3$ in dividend. Right?! If the next year the company has not been able to increase its revenue and earnings, but wants to increase the dividend anyway because its management knows that investors will yell if they don’t get their increase (or because they want to stay on the Dividend Aristocrat’s list), then the managers might decide to increase the payout ratio to give a greater dividend.
For sure, if the dividend growth is bigger than revenue and earnings, then it might be because they bought back shares and increased the payout ratio at the same time. But, there’s obviously a limit to what they can do! If there is no growth, than eventually, the payout ratio will be 100% or more and then the company won’t be able to maintain its competitive advantage by investing in CAPEX (capital expenditures)… In these cases, the dividend will eventually be cut.
I want to see a reasonable payout ratio (30-60%), growing revenues, growing earnings, growing dividends and if they have a share buyback program, I want to see the number of shares outstanding go down.
This citations comes from one of Warren Buffett’s letter to shareholders :
Since 1970, our per-share investments have increased at a rate of 19.3% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the 43-year period has increased at a rate very similar to that of our two measures of value. Charlie and I like to see gains in both sectors, but we will most strongly focus on building operating earnings. (Warren Buffett)
Warren Buffett has been able to show the power of that. And that’s why he keeps focusing on creating sources of income for his company. An increase in the income and profit drives it all!
Step #5 Healthy debt management?
Businesses who always need leverage to grow and make a profit are riskier investments. I seek to invest in business who are able to grow with the efficient use of their cashflow!
If a company always needs to emit bonds or shares or get loans to operate and make a profit then I’ll pass.
To assess this and get a big picture of how a company manages its debts, we can use three ratios :
debt/equity ratio – I like to see it below 1. The lower the better.
Quick ratio & current ratio – I like to see them over 1.
The purpose of these ratios is to measure the capacity of a business to cover its engagements. It is very important to verify these ratios and to make sure that the business you invest in won’t go bankrupt. Investigate all recent major changes in these ratios. Sometimes, businesses will cary more debts to make a strategic investment. The debt/equity ratio might suffer for a while but it might be okay. But, generally speaking, I like to see a decreasing trend on the debt/equity ratio.
Step #6 Is it undervalued?
Valuations of stock is more an art than a science. As such, there is always a margin of errors when we estimate the fair value of a stock. In the end, no one knows what the future will look like for sure.
Because of that, if you decide to try to assess the fair value of a stock, be conservative and prudent and keep a healthy margin of safety.
Value investors have created tons of tools over the years to help them compare companies and stock prices. The best one that is widely used is the DCF or discounted cash flow calculation.
Warren Buffett taught us that it is highly preferable to buy a great company at a fair price than a lousy company at a bargain.
Why? Because a great company is easier to manage, it’s cash flow is consistent and growing and so great that even a ham sandwich could manage it and make a profit! For compounding interest to deliver its full potential, you have to be invested in great companies. Every company will have to face headwind during its life cycle. But the less headwind it’ll will have to face the greater the profit will be over the long run.
I’m not going to explain here what is DCF calculations. Some already did it and offer great tutorials about it. I’ll pass the puck here.
Great valuation calculators
I usually use these 2 calculators that you can find here MoneyChimp. They have a great tutorial about how to evaluate a stock.
Here’s the direct link for the (DCF) calculator:
And here, you can find the Warren Buffett’s calculator (note that Warren Buffett never revealed exactly how he was performing a stock valuation) :
These calculators are used to estimate the current value of the futures earnings of a company. If the current price is lower than the intrinsic value estimated with the calculator, you then have a margin of safety and can decide to buy the stock.
Every investor has to decide what kind of margin of safety he seeks for. I will usually seek for a bigger margin of safety for a company that is less mature. For great company such as Wal Mart, Johnson and Johnson and others alike, I might be willing to pay fair value or even a premium because it is far better to buy a great company at a fair price.
I know! I’ve already said that! But it’s of most importance.
For sure, calculating the intrinsic value of a company remains what it is… it’s an estimate. See it as just another tool when you perform a stock analysis. Two investors could come up with fairly different values.
Benjamin Graham used to advise that we should only buy a stock if it sells with a margin of safety of at least 30%. Warren Buffett, his most well-known disciple, has made this assumption evolve with time and experience.
Other free tools
Other measures can also be used to verify if a stock is overvalued or undervalued. For example, I try to pay less than 20 times earnings (pe < 20) for a stock like Facebook (118 times), Amazon (625 times), Google (31 times). But, I’m confident that these stocks will eventually sell based on their fundamentals instead of based on expectations.
Warren Buffett once said that it’s when the tide goes out that we’ll see who’s swimming naked!
Stocks that sell too much over their value based on fundamentals (a business is there to make a profit) will see their share price drop twice as fast as fairly valued stocks based on their fundamentals if a big crash occurs… and it has happened and will happen again.
Finally, I use a lot Morningstar to compare different valuation measures such as : price/earnings, price/sales, price/book, price/cashflow and dividend yield. Morningstar offers 5 years and ten years averages of these numbers and also the industry and market numbers so you can compare your prospects with others.
Step #7 Technical analysis : is the timing good to buy?
Stan Weinstein taugh us that it is always better to invest with the trend.
While Warren Buffett has said that the most important thing to know is what will happen. When it will happen is not that important in the end.
Who’s right? While in fact they both are!
As a very long-term investor, I don’t give too much importance to the trend because a great company will make a profit even if the market is down or up. In fact, down market are great to buy shares of great companies while they are on sale. Be greedy when others are fearful is my motto!
Plus, by buying every month, I try not to play the market. Timing the market is not easy and it’s not something that anyone should try to do.
Anyway, market downs offer a margin of safety and can boost the total return of a portfolio if the investor has been able to amass tons of shares during the down period. But these are risky times also. One must cherry pick only the greatest companies shares.
These market downs generally occurs every 5 to 7 years… the last one was in 2008. So, during our life course, there are not a lot of these opportunities to seize.
During such market downturns, great company still make profit, they still rise the dividend and if possible, they might even buy competitors who are in difficulty (those who often carried too much debts). That’s how one can make extraordinary returns.
Shares of great companies usually are sold at a premium to their fair value. A good time to buy them is then on dips or market downs.
This is where technical analysis comes to the rescue. It can help “predict” but it is better to confirm dips or market downs and it can help verify the trend… will it most probably drop down even more?
Technical analysis is more an art than a science. But it can help. I usually use oscillators, moving averages, resistances and supports and I try to stay aware of cycles.
Lowell Miller (The single best investment), one of the greatest dividend growth investor out there, has dedicated a full chapter to technical analysis in his book.
My investing method is mainly derived or inspired by the following:
– Letters to shareholders of Berkshire Hathaway (Warren Buffett)
– Lowell Miller
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