Here is a summary of the information obtained so far:
- Company background and how they make money
- Dividend payout ratio
- Historical dividend growth rate
- Consecutive years of dividend growth
- Management’s future dividend growth objectives
- From this information, I estimate how much the dividend will grow on an annual basis in the future.
Dividend Yield % Plus Dividend Growth %
I like the sum of the dividend yield percentage plus the projected annual dividend growth percentage to be at least 8%. In fact, 10% or higher is ideal.
I won’t bore you with the finance theory. However, finance models suggest the sum of of these two percentages to be your expected future return on investment. Like this:
+ Dividend yield %
+ Projected Dividend Growth %
= Expected Future Return on Investment %
That’s why I like the sum of these parts to be at least 8%.
Most companies I analyze have one or more significant business risks they are trying to overcome or avoid. For example:
- IBM is struggling to transition from old tech to new tech products and services
- Southern Company is suffering cost over runs from constructing two nuclear power plants
- Apple must continually reinvent its products and services before they become technologically obsolete
- I can’t foresee the future, but I try to make a personal judgement on the company’s ability to adapt. I ask myself:
What is their track record?
Have they overcome significant business risks in the past?
Or, are they incapable of adapting? Will their challenges put future dividend payments and dividend growth at risk? These are tough and subjective assessments. But, I do my best to factor them into my decision to buy, sell or hold a stock. If it were easy, everyone would be a dividend stock millionaire.
Finally, I assess the value of the current stock price by looking at these two metrics:
- Price to earnings ratio
- Fair value using the Gordon Growth model
Price to Earnings Ratio
The company’s stock price per share divided by their earnings per share gives us the price to earnings ratio.
I prefer a price to earnings ratio below 20. This is not always possible especially after a multi year bull market run like we have recently experienced. In addition, high quality dividend growth stocks typically carry a premium valuation resulting in a higher price to earnings ratio.
Rather than set a strict limit, I look at the trend. Is the price to earnings ratio consistent with past years or is it significantly higher or lower.
If it is higher, can the company grow earnings fast enough in the future to justify the valuation? If it is lower, why?
Gordon Growth Model
Finally, I use the Gordon Growth Model to calculate a fair value for the company’s stock price and compare it to the current market price. The model considers several of the factors I have discussed thus far. Specifically,
- Current dividend payment
- Projected dividend growth
- My desired annual return on investment
Using the Gordon Growth Model valuation as a guide. And, after factoring in everything I have learned from the analysis, I determine the maximum price I will pay for a share of the company’s stock.
Buy, Sell or Hold? That’s a summary of how I form my decision.
How do you go about analyzing and selecting your investments?
And, here are a few recent dividend deep dives to check out….
- Compass Minerals
- Dominion Energy
- General Electric IBM
- Johnson & Johnson
- Philip Morris
- Realty Income
- Southern Company
- Wisconsin Energy
This article has been republished with permission from Dividends Diversify.