I don’t want to waste my time, do you?
What I like about dividend growth investing is that it turns out to be a super effective methodology and doesn’t take much time. You have to be sure to check out financial statements and take some time to think about the company’s business model. It’s not like investing was like picking an ice cream flavor during a hot summer day. It still requires some thinking. However, there is a way to cut corners and get directly to the point. Here are the four key ratios you need to look at before doing anything else.
Dividend Payout Ratios
The dividend payout ratio is probably one of the most important metrics for a dividend investor. Let’s keep it simple: if the dividend payout ratio is too high, the company can’t increase its dividend. Dividend growth investors are looking for a distribution that will be increased year after year. Here’s my mojo with regards to dividend payout ratio:
#1 Ignore any dividend payout ratio over 100%. You don’t want to pick a company paying more than its profits in dividends. This is completely ridiculous. It’s like clearing $2,000 per month with your pay check and contracting a monthly mortgage payment of $2,100.
#2 Calculate your dividend payout ratio yourself (click here to read why). There are several ways to calculate this simple ratio. It’s important you get your head around this crucial number.
#3 Spend little time on stocks with a ratio between 80% and 100%. Unless they show solid future growth, they will eventually fall in the 100%+ payout ratio category.
#4 Concentrate on stocks with a ratio under 80%. Ideally under 70% but hey, an investor has the right to take a few chances! Nonetheless, almost all my stocks show a payout ratio under 70%. This is why I can truly be assured of a sustainable dividend payout over time.
Dividend growth must be positive over 5 years. Why am I using a 5 year history instead of last year’s metric? Because I’m a long term investor. I don’t care if there was a dividend boost last year, I want to see annualized dividend growth over the last five years. I will obviously check yearly dividend payouts to make sure the positive growth isn’t coming from only one or two years. If I can find a stock increasing its dividend each year, then I’ve found a winner. If I can explain why a company didn’t increase its dividend for a specific period (e.g. banks in 2008-2009), I will consider the stock.
If the dividend payout ratio is under 80% and the stock keeps paying more money, we have the start of a good stock pick. But there is more…
Earnings Per Share Growth
Earnings, if there is one thing that matters when you are in business, it’s to make money, right? Similar to my criteria on dividend growth, I’m seeking stocks with a positive EPS growth over the past five years. I will also look at EPS year by year to see the trend.
Steadily increasing earnings means the company is always making more profits than last year. Combined with a low payout ratio and a positive dividend growth; we now have a company looking to reward its investors year after year. This is what I’m looking for.
Wait! I’ve added a fourth ratio; sales growth. What if a company increase its dividend each year and maintain a relatively low dividend payout ratio. This obviously means that earnings are also increasing. But what if sales are stagnating or, worse, decreasing? EPS growth means the company makes more profit but it doesn’t always continue to grow its market. This is why it’s important to look at positive sales growth.
If sales are up and earnings are up too, the company is in awesome shape and on its way to a healthy & increasing dividend.
That’s it? Really?
I told you that investing wasn’t like eating ice cream. I don’t think you can literally pull out your stock screener, enter these 4 metrics, close your eyes and pick any stock showing up on your screen. These four key ratios should be at the center of your investing process to find solid dividend stocks to start your research.
However, following my stock analysis template and the 15 things I look at a stock before making a trade, there is a lot more to consider. On the other hand, I believe that any stock not meeting these minimum requirements will not fit well in my portfolio.
Do you have any key metrics you follow each time you are about to buy a stock? What are they?