I started Dividends Diversify to bring structure to my investment process in stocks. To do this, I run my current holdings and potential stock purchases through what I call the Dividend Deep Dive. Let’s learn about it.
What kind of stocks are we talking about? Dividend stocks! As you might know, these companies have some similar characteristics. Specifically, they:
- pay out a substantial share of their earnings in the form of dividends
- periodically increase that dividend payment
- usually have a more mature business and business model
- provide essential services and products
- successfully adapt as consumers and markets change
- Furthermore, one of my favorite dividend stocks that has many of these characteristics is Realty Income.
With these company traits in mind, let’s take a look at some of the key metrics I review when performing a dividend deep dive on a company and its stock.
Dividend Stocks and Company Background
The first step is to understand what the company does. A few of the questions I ask are:
- How do they make money?
- What products and services do they sell?
- What markets do they operate in?
- How long have they been in business?
Dividend Yield %
The company must pay a dividend. And, the size of that dividend matters. The annual amount of dividends paid divided by the stock price equals the dividend yield. I prefer dividend yields in the 2-5% range. Yet, I do make exceptions and own both higher and lower yielding dividend stocks.
To pay dividends, a company needs income and cash flow. I calculate the dividend payout ratio for the past 7 years. The dividend payout ratio is the ratio of the total amount of dividends paid out to shareholders relative to the net income of the company.
A lower ratio is better. It means a company has a either a greater ability to increase the dividend in future years. Or, if they suffer an earnings decline, the dividend is more likely to be sustained until earnings recover.
I do not have a strict rule on how low the dividend payout ratio should be. I mainly like to understand the trend and how the ratio relates to the stability of the company’s business.
For example, a regulated utility company like Dominion Energy may have a dividend pay out ratio above 80%. Due to the stable and predictable nature of their business, this high level does not concern me.
On the other hand, a company more sensitive to the economic business cycles like Cummins is best having a ratio below 50%. A low ratio is necessary to ride out the potential volatility in their earnings, without needing to reduce the dividend.
Dividend Growth %
Next, I look at the trend in dividend growth. I calculate how fast the dividend has grown over the past 1, 3, 5 and 7 year periods.
I also check for how many consecutive years the company has increased the dividend. Some companies have annual dividend increases dating back more than 25 years. These companies are referred to as dividend aristocrats.
After that, I look through management’s information on the investor resources area of their website. I scan for their stated intentions for future dividend increases. Some companies will have clearly stated dividend growth objectives. Other companies will not.