In looking for the right dividend stocks, investors must look beyond dividend yield. The hot demand for dividend stocks has overvalued some income producers which has dropped their yields. The increased stock prices make these stocks a less attractive investment. Therefore, investors must take valuation as an important determent to a stocks potential return.
To stay away from value traps or cigar butts, investors should look at how the business model is performing. There is no perfect way to measure the business model but I prefer to look at the return on investment (ROI). Return on investment is simple the gain on investment minus the cost of investment divided by the cost of the investment. ROI is one way to determine the efficiency of a business and to compare the efficiency of a number of different businesses.
To find a list of stock prospects, I looked at valuation by using the forward price earnings ratio. Only stocks with a forward PE of 12 or less are included. The ROI to make the list is greater than 15. In addition, all stocks making the list are rated as Very Bullish by the consensus of analyst following the stock as identified by the equity summary score. This will help weed out the stocks that are cheap due to poor performance by management.
A prime example of how this screening works is with Homeowners Choice Inc (HCII), a small cap insurance stock. I discussed this stock in "High Yield, Low Beta Dividend Stocks With Plenty Of Growth Ahead" published on April 12, 2012. At that time, HCII was trading at $12.58 but now it is trading at $21.13. This is an increase of 68% since April so the stock must be overvalued. However, the stock still has a current PE of 9.52 and a projected PE of 9.1 for next year. HCII has an ROI of 24% and pays a solid 4.06% dividend yield. The payout ratio is only 24% so there is still room to grow the dividend. HCII is still a buy even after its price increase.
The best stock screens cast a broader net across the universe of stocks. For example, in health care pharmaceutical giant Eli Lilly (LLY) makes the cut with a forward PE of 11.6 and a ROI of 20.5%. However, LLY has only increased 2.65% year to date. So investors will need to settle for a safe 4.59% dividend yield. In comparison, investors may want to look at Span-American Medical Services (SPAN) that manufactures and distributes therapeutic support surfaces and related products for the medical, consumer, and industrial markets in the United States and Canada. SPAN has a forward PE of 10 with a dividend yield of 2.85%. SPAN is up 22% in price year to date. SPAN has been increasing its dividend since 2004.
There are several information technology stocks making the list. Seagate Technology (STX) is up 52% YTD but has a forward PE of 3.1 and a dividend yield of 4.01%. Technology giant Microsoft (MSFT) is up 17% with a forward PE of 10. MSFT has an ROI of 30 with a growing 2.65% dividend yield. Then there is IT services leader IBM (IBM) with a forward PE of 11 and a 1.67% dividend yield. As a microcap, Wayside Technology Group (WSTG) increased its sales by 30% in the first quarter. This is one stock to watch as it has a forward PE of 7.1 with a 5.16% dividend yield.
The energy sector is well represented on this list. Chevron (CHV) has a forward PR of 8.1 with a 3.43% dividend yield. Exxon Mobil (XOM) is similar to CHV with a forward PE of 10 and a 2.69% dividend yield. Marathon Petroleum (MPC) looks attractive with a forward PE of 6.8 with a dividend yield of 2.25% with a low 10% payout ratio. Investors looking for high yield should look at Pioneer Southwest Energy Partners (PSE). PSE added 14 wells in Q1 and has more coming online in 2012. PSE has a dividend yield of 8.15%.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.