When selecting a stock to invest in for the long term and permanently store wealth in, there are many qualitative criteria we want to look at. However, by definition qualitative criteria alone cannot help us to select a firm worthy of investment. There are other, metric based concerns that we must look at as well when evaluating a firm. These criteria will help us to score the stock and make finding investing ideas simpler, as qualitative criteria cannot easily be run through a stock screener.
First off, the criteria must be devised in a way so as to identify firms that meet your investing goals. My primary goal is to find high-quality firms I can store wealth in and diversify my income with. Once you have established your criteria, devise a method to weight your stocks against each other so as to help determine which ones are valid for further research. What follows is the scoring system I have devised for myself to research firms and the rationale for the criteria selected; feel free to devise your own and not take mine as any sort of recommendation.
There are many great criteria for selecting stocks, but our focus here is on valuation and the ability of the company to return cash to shareholders. The focus is on dividends for two reasons: we are looking for new income streams, and reinvested dividends on undervalued stocks supercharge overall returns. This focus will then drive our criteria for scoring a stock fur further investigation and possible investment. For me, the metrics most important to this goal are dividend history, dividend growth history, payout ratio, valuation, and overall yield. These all help to paint a picture of how well a stock will fit in my long-term goals.
The first criteria we will use is dividend history. The longer the stock has paid a dividend, the higher the score it receives. If a company has a long history of paying out cash to shareholders, they are more likely to continue paying in the future. Also, the longer the company has been paying a dividend, the greater the odds the company is a high quality investment through thick and thin. A quick glance at companies paying for more than 100 years can instantly illuminate some of the best firms in history: Coca Cola (NYSE:KO), General Mills (NYSE:GIS), Procter & Gamble (NYSE:PG) and Chevron (NYSE:CVX) have all been paying for over ten decades. Based on the firm quality, this makes the criteria for how long a company has been distributing cash a key metric for scoring our stock. The breakdown of the score is as follows:
New Dividend - 0
1-10 Years - 5 points
11-20 Years - 10 points
21-50 years - 15 points
50+ years - 20 points
This metric will immediately favor long, established firms with a history of payments, and will penalize cash machines like Dr Pepper (NYSE:DPS), Apple (NASDAQ:AAPL), and Gilead (NASDAQ:GILD). Many of these firms also have overvalued P/E ratios, but that will affect their performance in other categories.
It is key for firms to deliver cash to shareholders over a long period of time, however, longevity of payments is not the sole criteria by which to gauge their commitment to shareholder cash return. We also want to gauge a firm based on their ability to increase the amount of cash they are returning too. Therefore, we must also score the firm based on its commitment to raising the dividend. We can also see that firms with a history of increasing their payments also helps to find superior high quality investments; a quick perusal of the S&P 500 dividend aristocrats is to a quick glance at some of the best blue blood firms in American and international industry. With that, it follows that firms that increase their dividends regularly are superior operations to those that do not (exceptions not withstanding). The breakdown of the score is as follows:
0 years of increases - 0 points
0-10 years of increases - 5 points
10-20 years of increases - 10 points
20-25 years of increases - 15 points
25+ years of increase - 20 points
With this metric, higher weight is given to firms that have increased their dividends over greater numbers of year. Those who have been increasing for only a few years receive only a few points, and the titans of the dividend investing world receive a higher score. This metric helps to separate out low quality firms from high quality ones, and gives precedence to high quality ones. As a caveat, it will hurt firms that may have prudently froze their dividend during the financial crisis (Hershey's comes to mind) and those that are excellent firms now, but faced trouble and had to cut it in 2008 (GE & Wells Fargo, other financials, etc.)
Ability to Sustain Dividend - Payout Ratio
It is great and all if firms have been paying dividends for years and increasing the payments, however, that can come at a cost. If a firm has been growing the dividend but not growing revenues at an equal or greater rate than the dividend, the dividend payment has a good chance of becoming unsustainable. A good example of this is Procter & Gamble: the firm is very high quality but has barely grown revenues over the past few years while still growing the dividend. Now, shareholders are only seeing token 1% increases. Therefore, low scores will be given to companies with a high payout ratio, and high scores to ones with low payout ratios. Payout ratio is defined as the annual dividend per share / annual earnings per share, and the breakdown of the score is as follows:
100%+ - 0 points
80-100% - 5 points
60-80% - 10 points
40-60% - 15 points
0-40% - 20 points
This metric will favor firms that have kept their dividend payout ratio low and operate disciplined dividend payout policies. It will also help those that prefer to return cash with buybacks, and ones that may have more cyclical earnings. However, this metric is the most important to me as payout ratios are one of the better indicators of a company's ability to keep sending cash my way. Also, it is important to note that this metric may have to be tweaked for a REIT as they often pay sustainable dividends that are in excess of GAAP earnings.
Valuation is another metric that we need to consider when judging if a stock is a quality firm in which to store our wealth. While valuation is not as important to us as we are never looking to sell the firms we purchase to store wealth in, it is still good to not have to pay too much to acquire a quality firm. Low P/E stocks also have a way of delivering superior returns over the long term, as reinvested dividends at low prices can supercharge returns when the valuation becomes greater. Valuation is also important because the cheaper the firm, the more dividends we purchase per dollar invested. For this metric we will use the Price to earnings ratio, or the current price divided by the firm's annual earnings. The breakdown of the score is as follows:
25+ - 0 points
20-25 - 5 points
15-20 - 10 points
10-15 - 15 points
0 -10 - 20 points
I know I said overvaluation doesn't really matter to me as much, but I still highly loathe an overvalued stock. It means I will have to likely dollar cost average into my position, and not build a large position all at once. I also don't like to overpay for things, which is disheartening as many high quality firms are not attractively valued today. Also, as with payout ratio, an adjusted metric will have to be used for REITs.
Last, and possibly most important, is the dividend rate. This is a metric that we need to be careful with to begin. A high-yielding firm may be in danger of cutting their dividend, and the dividend is only high as the firm has dropped drastically in price to reflect the possibility of an impending cut. Also, a high dividend can reflect a firm that has increased dividends too fast and earnings may not catch up. Dividend investors may find themselves susceptible to something called yield chasing as well, and this can lead to investments in a poor firm. Therefore, this metric will also be unusual as it will also decrease after it goes up. The breakdown of the score is as follows:
0-1% - 0 Points
1-2% - 5 points
2-3% - 10 points
3-4% - 15 points
4%-6% - 20 points
6-8% - 10 points
8%+ - 0 points
As a company leaves the sweet spot of a 3%-6% dividend rate, it gets docked more the farther it gets away from that range. High-yielding stocks are automatically dinged, as they may be unattractive per the reasons listed above. Scoring them lower also helps to defend against yield chasing, as higher yielding stocks will likely receive a lower overall score.
Drawbacks to this Method
There are several drawbacks to this method that will need to be considered. First off, several high quality firms will often score poorly. For example, Coca-Cola is a best in class dividend stock and only scores 55 points on this scale. There is also a large possibility that a poor firm might score well based off these metrics. Therefore, the score calculated here is only a starting point. In my opinion, any firm with a sore of 50 or higher is worth further research. What then might that further research look like? Dividend growth percentage over the past 5-10 years is important, as firms like P&G and AT&T (NYSE:T) have been limping along in total % but still score relatively well on this scale. Debt to equity is also important, as a high debt load can imply that a firm may not be able to increase the dividend further or may even be on the brink of cutting it. The PEG ratio can also be important, as it will score the company's ability to grow earnings, and earnings growth can mean dividend payment growth. You will also need to consider the qualitative factors that are linked to at the beginning of this article, as numbers alone cannot tell the full story of a stock.
The scoring method presented above is just one way to rate your dividend stocks. You can include more metrics, subtract some away, or substitute other metrics. It is only a way to identify firms for investment, as the metrics alone cannot determine if you should invest in a stock. When you purchase a firm to inventory wealth in, you need to be confident that you can sleep well holding it, as you ideally will never sell one of those firms. That means scoring the stock well, and completing plenty of follow up research. This is merely a start, and not the conclusion.
Disclosure: I am/we are long DPS,PG,WFC,KO,CVX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.