Given the low interest rates and the dangers associated with bonds in such an environment, dividend stocks are becoming more attractive to income seekers but there is more to analyzing a dividend stock than just looking at the yield.
Desired Characteristics of Dividend Stocks
- Strong Franchise
- Consistent and Predictable
- Strong balance sheet so that dividends can easily be paid
- Dividend payout
- Dividend growth
The word franchise is used to define a company with a strong brand, a good business model and one that generates returns that exceeds its cost of capital.
Since you are looking for a company that can continue to pay shareholders, the business must have a moat. You are not looking for high flying growth stocks, but one that is well run and where growth might have slowed down, but the company makes so much cash day in and day out, that even after the dividend payment, it has plenty of cash to utilize for the business.
Quick Check for Strong Franchise using EPV
A quick check to see whether the company has a strong franchise is to compare the EPV (Earnings Power Value) with the book value or net reproduction value.
This is a concept from the Earnings Power Value model created by Prof Bruce Greenwald. Rather than get into the full details, the short version of it is that if EPV is greater than the net reproduction value, the company has a moat.
Net reproduction value is the money it will take for anyone to "reproduce" the same business from scratch. A company where EPV is equal to its net reproduction value or less than the net reproduction value is a company with no moat and one that destroys value and cannot sustain its business in the face of competition.
The graph below represents the an ideal scenario where the EPV is greater than the net reproduction value.
Microsoft clearly has a moat. They have a strong brand that cannot be just reproduced overnight along with competitive advantages in the OS and office industry.
Consistency and Predictable
When looking at dividend stocks, you want to buy companies that have consistent and predictable margins. This is also true for the balance sheet and cash flow statement.
A company with a consistent balance sheet will ensure that financial risk of collapse does not occur, and likewise for the cash flow statement, steady growth in cash from operations and free cash flow or owner earnings are all good signs to look out for.
There are a few ways to check for consistency and predictability to find a great dividend stock.
How to Check Consistency and Predictability
From the Katsenelson Absolute PE model, there is check to "Determine Earnings Predictability" as shown in the image below.
Look at how gross margin, net margin, earnings and cash from operations has been trending. In the case of Microsoft, numbers have been inconsistent over the past 5 years which is Microsoft's weakest point. You don't have to end the check for consistency here.
Another check you can do is to look at the financial statements and check whether the company is free cash flow positive and whether it has been increasing.
Microsoft gets zero stars for consistency over the past 5 years (0 stars)
Strong Balance Sheet so that Dividends Can Easily be Paid
Checking the balance sheet will let you know how healthy a company is. What you don't want is a company that is heavily loaded with debt and paying dividends. There are some companies where they continue to pay dividends by issuing debt, just to prevent disappointing investors and leading to the stock falling. You can ensure this doesn't happen by analyzing the balance sheet ratios.
Reviewing the Solvency and Capital Structure Ratios will give you a very good picture of the company debt structure.
The dividend payout ratio is different than dividend yield in that it looks to see how well earnings support the dividend payment. If the ratio is low, it means that the dividend is easily covered by earnings and the company will not issue debt to pay dividends.
A point to note is that mature companies tend to have a higher payout ratio because it will distribute more of its cash, while growing or smaller companies will have a small payout ratio because it will use the cash to fuel further growth.
The formula for the Dividend Payout Ratio is
Dividend Payout Ratio= Dividend / Net Income
The dividend payout ratio can also be adjusted to use free cash flow instead of net income.
Dividend Payout Ratio= Dividend / Free Cash Flow
The payout ratio can be easily calculated by going to the EPS section of the income statement where EPS and dividends per share are located.
I've left the most obvious part for last. Dividend growth.
To continually generate income from your portfolio, you need to find companies that will increase their dividend each year. There are many companies that issue a high yielding dividend, but then the problem becomes the dividend staying at the same level despite growth in earnings and cash.
In order to determine whether a company will continue to increase the dividend, you look to see what the growth is for net income and free cash flow.
Net income peaked in 2011 and 2012 along with TTM numbers show a decline, but this has not translated into a reduction in free cash flow as seen below.
It would be safe to assume that Microsoft will increase its dividend in the following year as well.
Microsoft gets a star for its dividend growth (1 star)
Microsoft is a 4 star dividend stock.
Do Not Forget Valuation
Lastly, with any company, don't forget valuation. Since safety seeking investors flock to buying dividend companies, there is a risk that you may be paying too much of a premium.
Lately, there have been claims that dividend stocks are becoming a bubble because people have been rushing to buy dividend stocks to avoid 0% interest in their banks and the danger of bonds in a low interest rate environment. Whatever the case may be, make sure the company is cheap or fairly valued based on several valuation models instead of focusing on just one.