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For a while I have been pondering a method for ranking dividend growth stocks (stocks that increase their dividend payout each and every year). This Seeking Alpha article was the catalyst to putting my thoughts on paper. I want to apply a weighted decision matrix to a list of stocks to determine the most favorable dividend growth stocks to invest in.I am going to start with David Fish’s list of challengers (5-9 years of dividend increases), Contenders (10-24 years of dividend increases), and champions (25+ years of dividend increases). The list I am using is dated 30-Sept-2011. The latest version is available here.

The list starts with 450 companies. I removed the companies classified as being in the banking industry, the ADRs, and any companies noted as splitting into two or being bought.I also removed REITs and MPLS since they take special analysis.This screening reduced the list of stocks down to 317 companies.

Here is how a weighted decision matrix works. First, you choose the criteria to evaluate, then you rank them in order of importance, highest to lowest. Then you sort each stock you want to evaluate by its place or rank for each criterion. For example, out of ten stocks, the stock with the best metric has a rank of 10. If the weight is 5, then the score for that stock is 10 x 5, or 50. Finally, you total each stock's scores for all the criteria and rank the results from highest to lowest. An example would be best.

We have to determine the criteria we want to grade these companies by.As mentioned in other Seeking Alpha articles, having too many metrics to rank can dilute the results and may result in a lot of overlap since so many financial metrics are tied together. The five I have chosen are Payout Ratio, Next Year (NY) EPS Growth %, 5-Yr Dividend Growth Rate (DGR), NY Yield, and 10-Yr DGR.

The next step is to rank, or add the weight to, each of the five criteria I have selected. There are a couple thousand different ways to order them, and each individual may select a different weighting.

Weight 5: Payout Ratio

I am giving the payout ratio the highest weight.The payout ratio is the easiest measure of the company’s ability to pay its dividend.We want dividend growth for many years to come. Normally, I look at a company’s dividend $ per quarter divided by its free cash flow (FCF) for the same quarter. Since Mr. Fish has the EPS payout ratio in his matrix, I will use that for this example.

Weight 4: 5-Yr DGR

The goal of my dividend portfolio is to have an increasing dividend each year, so I am weighting the 5-yr DGR rate as 4.

Weight 3: Yield %

We are all after yield, correct?Yield is the dividend investor’s return on investment (ROI). In my original draft, I had given yield a weight of 2, but that just did not feel right.Yield also acts as a value of the company’s stock price.If the company’s stock price is overvalued, chances are its yield will be lower than its peers'. This is another reason why I moved yield up to a weight of 3.

Weight 2: NY EPS Growth %

In order to continually pay a higher dividend, a company needs to generate ever higher EPS. If all other factors are equal, the companies with the higher EPS growth should be able to increase their dividends the most.

Weight 1: 10-Yr DGR

Finally, I chose 10-Yr DGR. Not all companies will have a 10-Yr DGR, so that is a little unfair, but it seems a company that has increased its dividend for 15 years, should have a slight advantage over a company that has increased its dividend for only 5 years (even though the last 5 years have been a difficult time for companies to increase their dividends). Also, for the companies with 15, 20, or even 25 years of dividend growth, they should be sorted by how strong their DGR has been over the past 10 years.

Here are the top ten companies by Payout Ratio:

[Click all images to enlarge]

Here are the top ten companies by 5-Yr DGR:

Top Ten Companies ranked by thier 5-Yr Dividend Growth Rate

Here are the top ten companies by Yield (%):

Top Ten Companies Ranked by thier Dividend Yield

Here are the top ten companies by NY EPS Growth %:

Top Ten Companies Ranked by thier NY EPS Growth %

Here are the top ten companies by 10-Yr DGR:

Top Ten Comapnies ranked by thier 10-Yr DGR

Finally, to pick the winner(s), you add each company's five individual scores together to get a total score/rank. Here are the final top ten:

Top Ten Companies

This is by no means a buy list, but it would be a great place to start some fundamental research.In a follow-up article, I am going to show a small variation to this strategy and try to apply some guidelines for investing.

Disclaimer: Author is not responsible for typographical errors or errors in data, whether error is from the source or author's calculations.

Source: Quantitative Method For Ranking Dividend Growth Stocks