I wrote my first article last week on dividend growth rates and I received many comments regarding what my upcoming article(s) should be on. While I have a few more in the pipeline I think this one will help the most people, but may be the most controversial. I came up with a theorem that mathematically distinguishes one company's dividends from another. This is a theory I spent weeks perfecting, and while you may marvel in its simplicity, it is much more complex than meets the eye. I will use well-known companies such as Coca-Cola (NYSE:KO) and ExxonMobil (NYSE:XOM) and ConocoPhillips (NYSE:COP) among others, and I encourage you to make an "educated" guess as to which one is best for future dividend growth, then we'll put them through my formula, and I think you will be surprised with the results.
The theory introduces a quantified way to view dividends instead of guessing between two that may look similar, but in fact, there is a measurable gap between them. Therefore, there is a measurable gap between which dividend is best supported by earnings and has room to grow. This may sound complex, but it is simply the quotient of two numbers commonly used by dividend investors while analyzing a company. The closer the solution is to 0, the better buy the stock used in the equation becomes. You can employ this strategy by using the metrics of an individual company and determine if it meets falls below your desired solution. You can also compare many companies that have very different metrics and determine which is best for a dividend portfolio. You can determine which company you'd recommend purchasing between two companies with very similar payout ratios and dividend yields with this quantifiable theorem. The solution is an emotionless way to look at a company. The results should be a pleasant surprise and a new way of judging companies that pay dividends, not all dividends are created equal.
(On a calculator: Company A, 25/5 = 5; for Company X, 50/2.5 = 20).
Payout ratio as percent %
Dividend yield as percent %
.05 - (5%)
.02 - (2%)
.025 - (2.5%)
.025 - (2.5%)
.1 - (10%)
.03 - (3%)
- A solution above 30 should not be considered. These companies either have a poor dividend program or too high payout ratio. Little or no room for future dividend growth.
- A solution between 30-20 should the highest solution considered. These companies either have too high of a payout ratio or too low of a dividend yield and should usually be passed over.
- A solution between 20-10 should be considered an above-average dividend company and should under consideration for purchasing shares. Have a fair payout ratio dividend yield, but not compelling.
- A solution of 10 or less should be considered an exceptional dividend company because of a low payout ratio and a high dividend yield, and its shares are a compelling buy.
The solution helps you visualize the difference between Company X that has a 2.5% dividend yield and a payout ratio of 50%, and Company A that has a 5.0% dividend yield and a payout ratio of 25%. You may look at this and think this is a no-brainer. Company A is a 5 and Company X is a 20, and it's obvious there is a big difference between the two. You would probably recommend buying Company A because you know there is plenty of room for future dividend growth because their solution is smaller because they benefited (lowered) by having a higher dividend yield coupled with a lower payout ratio.
Company A appears to be the distinguishable winner without any other information, and most likely you would recommend purchasing their shares. Company A appears to have more growth, more room to increase dividends, and earnings can stagnate for a few years without affecting the dividend because of a healthy payout ratio. Furthermore, most likely you would not recommend purchasing shares, in Company X because their solution of 20 is much higher. You may even want to sell if you are a stockholder because their future doesn't look like it has much growth. Company X appears to have lower growth, less room to increase its dividend, and if earnings stagnate for a few years the dividend could be put in jeopardy. The higher solution means that they have a higher payout ratio and/or a lower dividend yield, not a desired quality for a dividend growth investor.
However, you may be surprised to know that Company A has similar numbers to ConocoPhillips with a 6.9 solution (32.4/4.65) and Company X has very similar numbers to Coca-Cola with a 20.11 solution (52.3/2.6). Could you recommend someone buy the oil super-major ConocoPhillips, and sell the most recognizable brand in the world, Coca-Cola? Interestingly, both companies have increased payouts at roughly 9% yearly over the last decade so dividend growth isn't a pro or con for either company, ConocoPhillips clearly has the edge.
Another example is Royal Dutch Shell (RDSA), Chevron (NYSE:CVX), and ExxonMobil . RDSA has a 4.0% dividend yield and a payout ratio of 36.2%, and CVX has a 3.1% dividend yield and a payout ratio of 28.1%, and XOM has a 2.5% dividend yield and a payout ratio of 22%, so which company is the best dividend stock? Their solutions are 9.05, 9.0645, and 8.80 respectively. Personally I would rule out Shell because they dilute the share float regularly and have no effective buyback program. If I had to choose between Chevron and ExxonMobil, I'd pick ExxonMobil not just it got a lower solution, but because Chevron looks like they have a situation in Ecuador about dumping chemicals in the rainforest. The solution is not a "one stop-shop" for buying stock, but can effectively be used in conjunction with criteria you currently use. This formula can be used cross-sector, cross-industry, or cross-exchange, however I must admit it may not work for MLP's or REIT's (or similar), as I don't have enough knowledge to write about those companies with any conviction. Please let me know if you find a formula that works for something other than a stock or index.
While the math is simple, there are many hidden factors that most investors look for while researching a company. Important metrics like earnings can be seen within the solution because a company with a lower payout yield will always have a lower solution and because earnings are used to calculate the payout ratio. Additionally, share price is also factored into the solution because the higher the share price, the lower the dividend yield is; which means the solution will be higher. Share price is used to calculate dividend yield. It's a hidden, built-in safety feature. If earnings aren't growing and the shares are trading for a premium, this formula will catch it and spit out a higher number. This formula on the surface only covers payout ratio and dividend yield, but a deeper analysis shows that earnings and share price are included.
The solution is merely a snapshot in real-time of a company and the number gradually changes thousands of times a day. Apple has the best solution I could find with 12/2 = 6, is it a screaming buy? Overall I believe this to be an eye-opening theory and can help to calm emotions during times of panic selling or over jubilation. Are the low numbers always a buy? Are the high numbers always a sell? Is your love for a company with a high number the reason you can't sell it? Does this formula's equation, take the most illogical and irrational thing in history, emotions, out of the equation?