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Good question! It appears to me that for some investors this means doing a traditional fundamental analysis. In my humble opinion, this is wrong, or (at best) misleading. Fundamental analyses were developed to pick out "good" stocks with the hope that the market would favor them, the price would rise, the analyst would get rich (and live happily henceforth). We, the Dividend Growth group, don't have that problem. We know "good" stocks - they pay dividends that grow. This information is published for all to see. We don't need the market. With limits on minimum current yield and dividend growth, a large list of potential candidates can be pared down to a manageable number. If you further screen using traditional metrics, make sure they correlate with dividend growth. Otherwise, you are eliminating potentially valid dividend growth stocks. Also, many fundamental metrics, ROE (Return on Equity) and D/E (Debt/ Equity), for example, are industry sensitive and a single cut-off number just reduced your list for no reason.

Case in point, the plot below shows 32 dividend growth companies with their ROE and 5-year Dividend Growth values.


(Click to enlarge)

Here, the y-axis (vertical) is 5-year Dividend Growth (from dividendinvestor) versus x-axis (horizontal) 2012 ROE (from Morningstar). I see no reason to discard the 6 on the left because their ROE is less than 15. If there was any correlation between these 2 parameters, it would show as some pattern in the graph; there is none. Full disclosure: these stocks are cherry-picked. I own all in my portfolio; but they were not chosen for high ROE.

Companies involved are: Procter & Gamble (PG), Kimberly-Clark (KMB), Automatic Data Processing (ADP), BlackRock (BLK), Target (TGT), Safeway (SWY), Ameriprise Financial (AMP), Walgreen (WAG), Illinois Tool Works (ITW), Praxair (PX), Norfolk Southern (NSC), United Technologies (UTX), Union Pacific (UNP), Eaton (ETN), CSX (CSX), Williams (WMB), Medtronic (MDT), Becton, Dickson (BDX), Johnson & Johnson (JNJ), Owens & Minor (OMI), Flowers (FLO), Hasbro (HAS), VF Corp. (VFC), PepsiCo (PEP), General Mills (GIS), McDonald's (MCD), Darden Restaurants (DRI), AstraZeneca (AZN), Sanofi (SNY), Xilinx (XLNX), Intel (INTC), KLA-Tencor (KLAC).

So, what is a poor soul to do? In this article, I will describe a methodology I use to decide whether or not to buy (or put on a watch list) a candidate dividend growth stock. Let's be clear; I am talking in this article about dividend increases that have an exponential growth rate. This includes most "normal" companies. For clarity, it does not include utilities, telecoms, REITs, BDCs or MLPs. Those equities have a linear dividend growth pattern. Their "due diligence" concepts will be treated in a future article. The name of the game is to conduct a series of tests with increasing complexity, weeding-out unsuitable stocks with a minimum of effort. Another point; I am focused on dividend growth. Some authors give lip service to dividend growth, then focus on yield. Not here! For me, yield merely states the cost of buying dividends and, after purchase, has no bearing beyond that, except for calculations that serve to judge the relative performance (of dividend growth) of stocks in a portfolio. Tools and metrics used in tests will be discussed as they appear.

Test #1: Determine current yield and current (one year) dividend growth. I use the "dividendinvestor" website. Yield, 3 & 5-Year dividend growths are shown in close proximity. This website has up to 5 (FREE) years of dividend data (click on dividends). The website uses dividend payment date for an annual summation of dividends, which in a few cases slop over into the next year; one year gets 3 payments and the next gets 5. These anomalies I correct, since it is readily apparent. Here I also eyeball how the dividends grow over time to see if dividend growth is reasonable. If you mix sources for dividend data make sure they are compatible. If Yield times dividend growth is small (less than 20) by a mental calculation, forget that stock. Y*DG is a FOM (Figure of Merit) I use to determine the desirability of a stock. I make no claim as to its invention, having read about it several years ago. I did derive it mathematically and reported on it in a previous SA article. Again, this formula is for exponential dividend growth only. There is a similar formula for linear growth. Here I calculate the 1-year dividend growth and FOM. Use your own lower limit for Yield; mine is about 2% and a FOM minimum of about 16. It is surprising how many hot stock tips fail this test. Keep in mind that a big swinger in dividend annual variations is the state of the economy where your prospective company does business.

Many investors have a 3% lower limit on Yield. Be careful about throwing too many babies out with the bath water. The curve below show these parameters for 2 likely stocks. One, 3% yield, 7% dividend growth; two, 2% yield, 15% dividend growth. The set of curves show yearly dividends for a $100 investment.


(Click to enlarge)

If your time horizon is greater than 6 years (in this example); the lower yield, higher dividend growth is the winner. Note, FOMs are 3*7=21 and 2*15=30; the higher, the better. Stocks with equal FOM are valued equally, higher yield near term and higher dividend growth in the out years. An example using pertinent numbers is a yield of 3%, dividend growth of 10% and a yield of 2%, dividend growth of 15%, both having a FOM of 30. The crossover is 9 years. Stocks with exponential dividend growth are selected favoring higher growth rates to provide larger income in later years. Near-term income is best provided using stocks with linear dividend growth, they have a higher yield. My portfolio is equally split between the two.

If you had a list of companies that have dividend growth, rank-order them by FOM using this easy test. Then, start with the highest and perform the tests below. If the original line-up isn't suitable, that will sort itself out.

Test #2: Read the Profile about the company's business. Here I use "money.msn" and "finance.yahoo" websites. It is vital that you understand the company's business model and its product(s). If these products may not be around at the end of your time period (in your judgment), are they adaptable to new ones?

Test #3: Determine an 8-year composite dividend growth. I use 8 years to cover an average business cycle. Shorter periods may miss market downturns and it is harder to find dividend data for longer periods. I use a non-linear regression analysis using 8 years of dividend data. The technique is described in one of my previous articles. What this does is calculate a "best fit" exponential curve to the presented data. I have a spreadsheet dedicated to this task, which facilitates the effort. Heavy-duty calculations are performed with the help of a website. If you don't want to go through the regression bit, just enter the dividend data in a spreadsheet and graph it. Or calculate the 7 annual dividend growth rates and see how they vary over the time period.

The curve below shows an example for ITW for the years 2005-2012. The green line represents the "best fit" for a 12.6% growth rate. The red line is actual dividend data. A measure of how well the calculated curve fits the data is 'r', the correlation coefficient, with unity (1) being perfect. Here r=0.94. The last year's dividend growth was 5.8%, which with a 2012 EOY yield of 2.43% gives a FOM of 14, at my low end. I selected this example to show how difficult it is to see what is really happening with dividend growth when all you have is 1,3,5-year averages (at best). Usually, the investor selects just one of the above and wings it from there. It is clear here that ITW had very good dividend growth prior to the financial crisis and since then much lower rates.


(Click to enlarge)

The question is, will ITW again become a 12.6% dividend growth stock? If you were looking at this prior to buying, you would probably pass. Analyzing it from a hold or sell point of view may be a different matter. Not to forget, ITW is a cyclical stock. You may not fail too many companies with this test, but you should get a pretty good handle on how the company's dividends vary year-to-year.

In the spreadsheet dedicated to determining this Composite Dividend Growth Rate, I color-code the cell containing the stock symbol, green-yellow-red, to reflect level of concern. This provides a quick ID for stocks to monitor closely during the year. While I am interested in growth rates for each stock, at that level, I am as interested in the shape of the curve. Downward trends trigger an investigation. I (try to) manage the dividend growth segment to be over 11% growth rate (weighted average). Since I am now there, I am less likely to sell ITW, which, maybe, is down due to the economy. ITW has a lot of activity overseas, in 58 countries, some of which are in recession.

Test #4: Use metrics to determine the worthiness of a company as a dividend growth candidate. Right out of the box, I tend to reject traditional fundamental metrics because of inherent flaws, In my humble opinion, in universal application and, in part, because they are not (may not be) applicable for dividend growth analyses. First of all, I would replace Net Income (earnings) with a cash flow substitute. The reason is that Net Income has been stripped of non-cash items in the Income Statement and does not reflect cash available to spend on the very factors we are interested in (dividends being one).

Second, I would not use any metric that uses Total Assets. Part of the makeup of Assets is a item called Goodwill. Goodwill is defined as the excess over Book Value that a company has paid for an acquisition. Originally, Goodwill was written off over time, but some years ago this was discontinued; the rules were changed. From a cynics point of view, if you grossly overpay for an acquisition, the excess is added to your Assets forever. Really!! Some of the companies we are dealing with have copious amounts. This is normal in some industries and in that respect unavoidable, but still, to me it is not an asset. ROE is unacceptable (for reasons we have seen), but it also has in the denominator the factor "Total Assets minus Total Liabilities." Total Liabilities includes Debt. So going deeper in debt increases ROE. Looking at ROE data in doing research for the first chart revealed that there were many instances where a company's ROE would vary significantly year-to-year, even going negative. There were 4 companies I could not include in doing the first graph of Dividend Growth versus ROE due to excessively large values of ROE. Besides, many (if not most) traditional metrics are industry sensitive and since we are looking at companies across many industries, their usage is not appropriate, In my humble opinion.

As a replacement for Net Income, I use a simple formula using data that is readily available. I would have used metrics like "Cash Flow from Operations" or similar ones, but in these cases either the metric was not inclusive enough and/or it called for data that was not handy. I call this new metric OMBA$ (OperationsMoniesBeforeAllocation Dollars). The formula is OMBA$ = Net Income + Depreciation + Amortization + Non-Cash Items. I use the money.msn website for these data; taken from the Cash Flow sheet, Operations section. This may not be exactly accurate, but it represents the bulk of "profit" in cash money that the company Board of Directors (with Management) have each year to allocate. Units for this metric are $/year. More will be said about this metric. It can be used to calculate a $Payout by dividing "Total Cash Dividends Paid" (Financial Section of Cash Flow sheet) by OMBA$. By the way, these formulas work for all companies including REITs and MLPs.

Another metric I have toyed with as a replacement for Debt/Equity is: Long-Term Debt / OMBA$. This gives the number of years it would take to pay off debt using the entire cash flow. Long-Term Debt is found on the Balance Sheet. I calculated this metric for 32 companies last year using the dividend growth segment of my portfolio (2011 data). The average was 1.6 years; 0.4 minimum, 2.9 maximum. I was surprised that the numbers were so low. It really says that dividend growth companies control their debt. It does bring up another issue in using metrics of this sort. Suppose a company borrows money to build a new plant. At first, debt goes up, taking this ratio with it. It may take a few years before the new plant is operational and contributing to cash flow. Rather than compare these metrics across different companies, it is more meaningful to track the metric over time with a given company. In this case, for example, if the ratio was trending higher, it might indicate the company was losing its grip in utilizing debt to boost income. I have pretty much given up on finding any further metrics to use, relying more on the next test.

As a test for new potential buys, do the $Payout and Debt/OMBA$ just to get calibrated. $Payout should run between 25-50% for these stocks. I would not think these need to be calculated every year thereafter, provided the next test is performed.

Test #5: Visual check of the company's Financial Statements. I use money.msn, they present 5 years of data, which are conveniently laid out. Hint: more data are available under some line items, click on the blue arrow. Also, when going to the Balance Sheet, it comes up with quarterly data instead of annual. Companies are required to submit these statements to SEC on a quarterly and annual basis. This agency does not pass judgment, merely makes them available to the public.

Financial Statements consist of an Income Statement, Balance Sheet and Cash Flow Sheet. I find the latter the most useful. Cash Flow is broken into 3 parts: Cash from Operating Activities, Cash from Investing Activities and Cash from Financing Activities. Values for Net Cash Beginning and Ending Balance are also provided. The line items within these categories that I use are: Operations - Net Income, Depreciation, Amortization, Non-Cash Items; Investing - Capital Expenditures, Other Investing Cash Flow Items; Financing - Total Cash Dividends Paid, Issuance (retirement) of Stock, Issuance (retirement) of Debt. All these data balance. If you start with Beginning Cash, then algebraically add the 3 Cash Groups, you end up with Ending Cash. In my view, the remaining line items vary throughout the year and are covered by the cash balance. The key items, in the Cash Flow Sheet, that we are interested in are those listed. Basically, we are looking to see how OMBA$ were allocated in our areas of interest.

As stated above, one factor in varying dividend growth rates is the economy. Dividends are determined by the Board of Directors (with Management). The test here is to review the annual decisions this group has made to see if you agree. The name of the game is "follow the money." If you feel proper decisions are not being made that are best for the Company and you (in small caps), then you should not own the stock. With their knowledge of the company's real financial position and goals, they are best qualified to make a proper allocation of available funds. This chiefly involves taking funds from Operations (OMBA$) and allocating them to paying dividends, stock buybacks, debt pay downs and investments (to grow and maintain the business). You see that all are important for dividend growth investors. If you agree that they made the right choices, you have a winner.

This is not meant to be a painful exercise. I believe it possible to just look at the Financial Statements, ask yourself some simple pertinent questions, search for the answers, and you are done. You know past dividend history. The question remains, can the company keep it up? For example, in all the companies listed above, all except 3 had significant stock buybacks in either 4 or 5 of the last 5 years. The money is there. My assessment is that they may be holding back (somewhat) in dividend increases because of the economy and the situation in Washington regarding our long-term fiscal problems. Also, the world economy is currently in pretty bad shape. I would not rush to sell just yet.

Yellow-colored stocks in my dividend growth segment, listed above, are FLO, ITW, PEP, AZN. All suffer from the malady shown in the graph of ITW dividends. I have no reds. It bothers me that these 4 companies have enough cash to buy back shares (in at least 4/5 years) rather than increase dividends a little more. If I cannot satisfy myself that there is a good reason, they be gone from my portfolio. I have a longer list of stocks in my portfolio that are paying a good dividend growth while also buying back shares. On the other hand, I am looking for a low turnover, low maintenance portfolio and need to focus on long-term performance. Decisions, decisions! And when I was young (and poor), I couldn't believe there were any problems with having money.

It is possible to get an inkling of future income flow by just studying the Financial Statements. An increasing trend in Net Income is obvious. An increasing trend in depreciation is positive. On the Balance Sheet, an increasing trend in Property/Plant/Equipment is positive. Allocation to Research (on the Income Statement), if shown, is positive. If one could detect them incurring debt to buy back shares, I would treat that as a negative. This eyeball analysis is more difficult with a service business; they are not big on depreciation, plant and the like. They sometimes do have cash going to and fro in Other Investing Cash Flow items, listed as 'Investments'. Remember, this is where art and science converge. Try to understand before passing judgments.

Let's take a look at ITW for the year 2012. The table below shows original cash flow balance in the first column and simplified balance, taking out small and/or transient items, in the second.

Data are in Million $

2012 Original

2012 Simplified

2012 Adjusted

Beginning Balance, Cash

1178

1178

1178

Cash from Operations

2072

2126 (OMBA$)

262

Cash from Investing

1047

1018

280

Cash from Financing

-1571

Dividends Paid

-865

Issue/Payback Stock

-1737

Issue/Buyback Debt

1015

1015

Foreign Exchange

53

Ending Balance, Cash

2779

2735

2735

The $1018M in Investing consists of the following: CapEx ($-382M); Acquisition of Business ($-723M), Sale of Business ($1120M); Sale Maturity of Investments ($281M), Other Investing Cash Flow ($722M). I believe that the $1120M Sale of Business was used to buy back shares, making that new amount $-617M. If we subtract from OMBA$ ($2126M) the following: Dividends Paid ($-865M), CapEx ($-382M), the new Stock buyback ($-617M), we have $262M left in OMBA$. These adjusted results are shown in the last column. Note: $Payout was 41%. If we 'spend' the remaining OMBA$ on part of the Business Acquisition (leaving $-461), what we have left is money from investment gains plus money from acquiring debt to (in part) acquire new business, rolling forward the remainder to the next year. A check of Long-Term Debt does show a $1101M increase. Long-Term Debt / OMBA$ was 2.2 years. Out of all that, couldn't they squeeze a tad more for dividends? Six cents more per share or $28M would have raised the 2011 dividend 10% (using 1% of the ending balance). If ITW is a 13% dividend growth stock, and I think it is, the dividends will get there over time. I just think it would be better to smooth out dividend flow by varying stock buyback.

The dividend situation was made murky by moving the January 2013 payment to December 2012, making total 2012 dividend payments look higher. It didn't take too long to ferret out all this, it took longer to write it down. All I really did was to 'spend' OMBA$ where it made the most sense in business terms using their expenditures and let the rest sort itself out. We don't need to go into as much detail with every stock in the portfolio. If the company is paying a good dividend and you are happy with the increases, then all that is needed is an eyeball check of Financial Statements. ITW was much more complicated than PEP, AZN or FLO. Sometimes it is difficult to determine if part of CapEx is to provide future growth. If so, part of CapEx could/should be paid for by issuing shares and/or debt, as is done with Acquisition of Business.

At first, you may experience difficulty in perusing financial statements because each company has a different business model. Companies in a given industry have common elements, but each company is unique. However, as long as a company pays dividends that are growing to your satisfaction, you don't really have a problem. This process does not lend itself to computer analysis, put metrics in the hopper and turn the crank, but it is a good way to get acquainted with what you own (or wish to).

This process should result in a sizable list of good dividend growth stocks, probably more than you have money to spend. Quite often, having found what I thought was a good dividend growth candidate, I purchased a smaller than normal position. If it had a good track record that would likely continue. If it does, it is better in the portfolio than on a watch list. I have had cases where dividend growth was a little disappointing, but capital gains were great. What a great sport!!

Source: What Is Due Diligence For (Exponential) Dividend Growth Stocks?