I use dividend growth and value investing as my primary investing strategy. Currently, early in the accumulation stage, I pool together incoming dividends and a portion of my income to make purchases. Right now, the dividends are significantly less than my day job contribution, however, I expect that ratio to balance out and eventually taken over by the dividends in a few decades. To create a solid dividend portfolio, the dividends must be safe, they must also grow so that the compounding process can be accelerated, and the total return of the portfolio should be acceptable.
The dividend portfolio consists of individual holdings. As long as each individual company is working well, the portfolio will work well. Using Target as an example, I will demonstrate how to determine if a company maybe a good addition or good holding for a dividend portfolio.
Dividends are Safe
When I'm considering a dividend stock to buy, I look at its payout ratio. For example, Target (NYSE:TGT) has a payout ratio of 56%, so it is paying out 56% of its earnings as dividends.
This is a decade's high for Target, as it is experiencing difficulties in its Canadian expansion, and the recent credit card breach did not help either. That said, I believe these bad news have been priced into the stock. And its dividend yield is also sitting at its 10-year high at 3.6%.
Target's competitor, Wal-Mart's (NYSE:WMT) payout ratio is actually sitting at 49%, which is not far off from Target's and also a 10-year high. So, this may mean that the whole discount retail industry is facing difficulties or problems. If you believe the industry will overcome these problems then it may be an opportunity to take a closer look at Target, which is the only company in its peer group marked with 4-stars by Morningstar indicating Target is undervalued.
As a dividend investor, I like to have a good starting yield, ideally a minimum of 3%, and I like that dividend to grow along with business growth.
Continue using Target as an example, its revenue has been in a general uptrend, although it seems to have plateaued in the last few years. Notice that it has plateaued before between 2007 and 2010 before continuing its uptrend.
It is reassuring for shareholders that management has been willing to share the business' success by increasing the dividend.
TGT Dividend data by YCharts
In fact, Target is a Dividend Champion, having increased its dividends for 47 years. Its 5-year dividend growth rate is 22.5%, 3-year's is 19.8%, and its most recent increase that will be paid in September for holders on August 20, 2014 is an impressive raise of 20.9%. Management seems to want to inject confidence into shareholders. (On a side note, David Fish, a popular SA contributor maintains a list of the Dividend Champions, Contenders and Challengers. Here is his recent article on Dividend Champions for June 2014).
Only Buy Companies at a Fair Price or at a Discount
The dividend income from a holding immediately gives a positive total return for our investment (as long as we don't sell the shares). However, we can't help it that in the short-term, the price of stocks goes up and down, and can be unnerving for a new investor. In all honesty, it's nice to see capital appreciation in my portfolio even though in the accumulation phase, I should really want prices to remain low so that I can purchase shares at lower prices. Ah, the dilemma.
To maximize total return, we should buy companies only when they're at a fair value or is priced at a discount. The estimated annual return of the company should also match our portfolio goals. Your goals may include:
over long periods of time, beating the average market annual return of 10%,
in 20 years, earning a certain number for your dividend income
having a starting yield of 3% and the dividends grow faster than inflation, say at 6% per year or higher
If I paid appropriate valuation for a good company, "then the dividend yield plus the long-term dividend growth rate should roughly approximate my total return because as that dividend rises, the stock price should follow it up certainly not in lockstep, but over a longer period of time we're going to have that correlation." - Josh Peters 
This reminds me of the Chowder Rule, which simplified, is generally looking for companies which have:
- current yield + the 5 year dividend compounded annual growth rate = 12%
Using Target as an example, it'd be:
- 3.6% + 22.5% = 26.1%
And 26.1% exceeds the Chowder Rule expectation.
Valuation is one of the most important concepts to grasp to ensure you're buying your shares at a fair or discounted price. Morningstar offers a simple star system so that you don't have to dig into the numbers if you don't want to. A 4 or better yet 5-starred company indicates it is undervalued.
(screenshot from Morningstar)
I want to buy and continue holding solid companies which pay a decent starting yield and growing dividend, and I want to buy them at a proper valuation if not at a discount. This ensures my portfolio will generate a growing income stream, while giving me steady price appreciation for the long-term, contributing to satisfactory total return.
Learn More About
- Dividend Safety: low payout ratio does not suggest plenty of room for dividend growth; wide economic moat companies, companies with strong balance sheets
- How to Pick a Value Investment for Dividend Growth and Success
- Set a Margin of Safety for your Total Return
- Dividend Yield as an Indicator of a Bargain
 The idea of this article came from this Morningstar video with Josh Peters about 3 Questions for a Solid Dividend Portfolio.
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Note: Please use this article as initial research material. Do your own due diligence before buying or selling a stock.
Disclosure: The author is long TGT, WMT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.