Important Metrics For Dividend Growth Investors

Includes: JNJ
by: David Van Knapp

Here is a selection of metrics that are particularly significant to dividend growth investors. Each investor has his/her own approach, so some of these may be less important to particular individuals than they are to me. On the other hand, I'm sure this list is missing some items that are extremely important to other individuals. So consider this a starter kit. In my own stock analysis, I use more metrics and factors than are discussed here.

These are presented in roughly the order of importance as I see them. Because I believe that it is important to keep units of measure straight in investing, I specify the unit of measure for each item. Sometimes the units will seem trivially obvious, but it is surprising how often investors get them wrong, then mix themselves up because they are trying to compare two numbers that are actually stated in different units.

At the end of the article I illustrate most of these metrics using screen shots from common sources.

Yield: The one-year percentage return on your investment from the dividend. Yield = Dividends / Price. Yield can be computed different ways depending on the 12-month period selected for the dividends. The calculation that I find most useful is projected yield, which is the yield you would get if all known information remains the same. The general formula then becomes Projected Yield = Next 12 Months' Expected Dividends / Price. So if you pay $50 for a share of stock, and the stock's most recent quarterly dividend payout was $0.50, and no dividend increase has been announced, its projected yield is 4% ($2.00/$50.00). If the company has announced an upcoming dividend increase, that amount would be used in calculating the projected yield. (The assumption is that the newly announced dividend rate will become the norm.) Projected yield is also known as indicated yield. The unit of measure of yield is percent.

Initial yield: Your yield on the day you buy a stock. While your current or projected yield will vary over time as the stock's price fluctuates and its payout rate changes, your initial yield is locked in. It is the lowest yield on cost that you will ever experience unless the company cuts its dividend. This is one of the key concepts in dividend growth investing. Unit of measure = percent.

Yield on cost: Your yield based on the price you paid for the shares: Yield on cost = Annual Dividend Payout / Price You Paid. The yield on cost will increase every time the company increases its dividend. Say that on January 1, you spend $100 for 5 shares in a company with a payout rate of $1.00 in the first year of ownership. Your initial yield is $5 / $100, or 5 percent. During the second year, the company increases its dividend to $1.10 per share. Your yield on cost jumps to $5.50 / $100, or 5.5 percent. Notice that yield on cost is a function of your company's dividend payout, but it is independent from the stock's fluctuating price. The original $10 per share that you paid remains your cost as long as you hold the shares, so the denominator in the equation does not change. Also note that yield on cost increases as you reinvest dividends, since the new shares purchased also push up the total dividends received. Unit of measure = percent.

Payout rate: The dollar amount of the dividend per share. Also called dividend rate. Contrast to yield, which is stated as a percentage rather than the amount. Unit of measure = dollars and cents.

Years of dividend increases: How many years that the company has consecutively increased its dividend. This number can be found in the Dividend Champions document compiled each month by frequent contributor David Fish. Commonly known as CCC (for Champions, Contenders, and Challengers), this document is the state-of-the-art source for finding stocks that have consistently grown their dividends for at least five years (Challengers), 10 years (Contenders), or 25 years (Champions). The document also has a wealth of other information. Dividend growth investors want dividends that are reliable, roughly predictable, and regularly increased. Companies accomplish this by managing their dividend programs to achieve those results. Such companies have managed dividend policies. They pay regular dividends on an established schedule that repeats year after year, usually four times per year . (Distinguish regular dividends from special dividends, which are non-repeating or occasional dividends.) Also note that while most American companies pay regular dividends four times per year, many foreign companies pay just once or twice per year, and the amounts of the payments are often irregular. Some companies pay dividends monthly. Unit of measure = years.

Dividend growth rate (DGR): The compound annual growth rate (OTCPK:CAGR) of a company's dividend. Annualized DGRs for 1, 3, 5, and 10-year periods can be found in the Dividend Champions document referred to above. Unit of measure = percent per year. The "per year" part is important: It means that yield (in percent) and DGR (in percent per year) cannot mathematically be compared straight across to each other. They are independent measures expressed in different units.

Compounded rate of return: To compound means to earn money on money previously earned, thus creating a snowball effect. Compounding occurs via two different mechanisms in dividend growth investing. One mechanism is the annual growth of the dividend itself. When a company raises its dividend, the dividend increase is added to the former dividend rate, creating a new base amount. Thus if a company paying a dividend of $1.00 per share increases its dividend 10 percent, the dividend becomes $1.10 per share. Next year, if the company again increases its dividend 10 percent, that increase is calculated on the expanded base amount ($1.10) rather than the original ($1.00). The new dividend becomes $1.10 plus 10 percent, or $1.21. (Had the dividend not compounded, you would have two independent increases of 10 percent on the original $1.00, or $1.20.) The second compounding mechanism occurs if you reinvest dividends. The reinvested dividends purchase more shares, which themselves generate more dividends in the future. Note that the two mechanisms operate independently. Therefore, your dividend stream will grow even if you don't reinvest the dividends, because the companies are increasing their dividends each year. And your dividend stream from a static (non-growing) dividend will increase each year if you reinvest the dividends. Unit of measure = percent per year.

Total return: The sum of the return from price changes and dividends. Price Change + Dividends = Total Return. Note that price change can be either positive or negative. The return from dividends, however, is always positive. Dividends cannot drop below zero. Historical annualized total returns are typically presented for 1, 3, 5, and 10-year periods on major financial web sites. Unit of measure = percent per year, or if the return is just totaled for all the years you have held a stock, the unit is percent.

Valuation: Valuation means appraising the inherent or intrinsic value of a stock and comparing it to the actual price at which it is selling. The result is an assessment of whether the stock is (1) fairly valued, or selling at about its intrinsic value; (2) undervalued, or selling at a bargain price; or (3) overvalued, or selling for more than it is worth. As with all appraisal processes, stock valuation involves estimates and has some subjective elements. Various terms are used to describe the inherent value of a stock: intrinsic value, fair value, true value, true worth, real value, and so on. Value investors attempt to estimate the intrinsic values of stocks in hopes of finding ones that are undervalued. A stock's inherent value may or may not be the same as the current market price per share, in fact they usually differ, markets being what they are. The intrinsic value includes variables that are difficult to quantify, such as the value of brand names, patents, trademarks, and copyrights. Other variables, while quantifiable, are difficult to estimate, such as future earnings growth rates. Different investors will use different techniques to calculate intrinsic value and will arrive at different results. Units of measure: For intrinsic value, dollars and cents. For valuation, terminology varies, but fairly valued, overvalued, and undervalued are often used. If valuation is expressed as a ratio of the intrinsic value to the actual price, the result is a unit-less number (a simple ratio).

Valuation ratios: Yet another way to value a company. "Valuation ratio" means any ratio of the stock's current price (P) to one of its fundamental financial numbers. That is, the price per share, P, is always divided by another dollar amount, X, derived from the business. X, for example, might be the company's earnings per share. That would render the common price-to-earnings, or P/E, ratio, which is the 800-pound gorilla of valuation ratios. Valuation ratios reflect the market's expectations for a stock and investor sentiment about it. The higher the ratio, the more the market expects from the stock, hence investors' increased willingness to "pay up" to buy it. Conversely, the lower the ratio, the more likely the stock is selling at an advantageous price. I use a variety of valuation ratios, including P/B (price-to-book), P/S (price-to-sales), and others. That enables me to assemble a valuation mosaic and not worry too much about whether any single ratio gets it exactly right. Often a single ratio is out of whack with the others. Common valuation ratios are readily available on financial web sites. Unit of measure = unit-less (a simple ratio).

Earnings per share (EPS): The company's reported earnings divided by the number of shares outstanding. Companies file earnings reports quarterly. The time period when companies announce their earnings is called earnings season, which happens to be going on right now for the quarter that ended in June. Dividend growth investors are very interested in earnings growth, because consistent dividend increases come from growing earnings. Unit of measure = dollars and cents for EPS; percent per year for EPS growth.

Price per share: The market price of a share of stock at any particular moment. Shares trade continually while the market is open, and even when it is not, so prices change continually. The efficient market hypothesis (EMH), per Investopedia states that, "…existing share prices… always incorporate and reflect all relevant information. [Thus]…stocks always trade at their fair value on stock exchanges." Most dividend growth investors, along with their value investing cousins, reject EMH on various grounds, such as un-disseminated information, inefficiencies in processing information, and trades being motivated by emotion more than logic. This phenomenon is embodied in the allegorical Mr. Market, devised by famed investor Benjamin Graham. Mr. Market (the market as a whole) appears each day Mr. Market and offers to buy or sell stocks at prices which may or may not reflect the true intrinsic value of the stock. Mr. Market is ruled by fear, greed, and apathy rather than by rational analysis. He has mood swings. The point of the allegory is that you should not interpret market price as indicating the intrinsic value of shares, as the market's behavior is often irrational. To see two interviews with Mr. Market of particular interest to dividend growth investors, see "Here s What Mr. Market Says: Ban Dividends" and "Mr. Market Says Dividend Investors Will Succomb." Price matters in dividend growth investing. First, dividend yields move inversely to stock prices. All else equal, the lower the price, the higher the yield. Second, you want to buy a stock for a price that represents fair valuation or undervaluation. Price movement is more likely to be upwards if you can get a bargain price to begin with. Third, if a stock becomes wildly overvalued, that may be reason to sell it. The capital gain may represent several years' worth of dividends that you can get all at once immediately by selling. Unit of measure = dollars and cents.

Beta: A measure of the past average variability of a stock's price in comparison to "the market," which is usually defined as the S&P 500. Stated another way, beta is an indicator of what the typical response of an individual stock has been to market swings. The measuring time is usually long (say 36 months) to obtain a representative average. A beta of 1.0 indicates that the stock's price has moved exactly in concert with the market. The S&P 500 itself has a beta of 1.0 by definition. A beta less than 1 (but more than 0) means that the stock has been less volatile than the market; so if a stock only moves on average 50% as much as the S&P 500 moves, it has a beta of 0.5. A beta greater than 1 indicates that the stock's price has been more variable than the market; so if a stock typically swings 30 percent more than the overall market, it has a beta of 1.3. A beta of 0 would indicate that the stock's price movements have no correlation to the market, and a beta less than 0 would indicate negative correlation (they move in opposite directions). Most dividend-growth stalwarts have betas below 1, meaning that they tend to be less volatile than the market itself. Unit of measure = unit-less number.

Ex-dividend date: "Without-dividend date." The first day that a newly purchased share of stock comes without the right to receive the next dividend. If you purchase a stock on or after the ex-dividend date, you will not receive its next dividend. So in order to be entitled to the next dividend, you must buy prior to the ex-dividend date, and you can't sell the stock until after the ex-dividend date. From the seller's point of view, the ex-dividend date is the first day on which you can sell the shares and yet still be entitled to receive the dividend. The actual dividend may not be paid for another few weeks, until the payment date. At the market's opening on the ex-dividend date, stock exchanges usually adjust the previous day's closing price downward by the amount of the dividend. The adjustment reflects the fact that the cash to cover the dividend no longer belongs to new buyers. For most stocks, this change in the previous day's closing price soon gets lost in the noise of the day's trading. Units of measure = month/day/year.

Payout ratio: The percent of the company's earnings that it pays out in dividends. For example, if a company earns $4 per share and pays $2 in dividends, its payout ratio is 50 percent. The payout ratio is sometimes computed on cash flow or free cash flow instead of earnings. Many investors believe that, all else equal, a lower payout ratio is safer than a higher one, because there is more cushion to maintain the dividend payout rate if the company runs into hard times for a year or two. Units = percent.

Sources for Information

Let's use some screen shots to see what these metrics look like in typical research sources. The first screen shot is from the Morningstar quote page for Johnson & Johnson (JNJ), which is a core dividend growth stock for many investors. On this first page, you can see JNJ's current price, its price history (I set the graph to display 5 years), the current yield, and some valuation ratios. You can also see Morningstar's star rating on the stock. Under their system, this star rating blends all of their various fair worth factors into a single estimate of the stock's intrinsic value. The four stars earned by J&J mean that Morningstar believes this stock is undervalued.

In this second excerpt from the same page on Morningstar, you can see J&J's recent dividend history, plus their projected yield. You can see that they raised the quarterly dividend payout from $0.57 to $0.61 (or 7.0 percent) in May, and that their next ex-dividend date is August 24. You can also see that the projected yield (using the $0.61 payout going forward) is 3.58 percent.

In this last excerpt from the Morningstar quote page, you can see what they call Key Stats, including three valuation ratios and 3-year average revenue growth and EPS growth.

On other pages for each stock beyond the quote page, Morningstar provides much more information for each stock. For example, on this interior page, Morningstar shows a variety of valuation ratios.

Another way to look at valuation is via Chuck Carnevale's popular FASTgraphs. In this screen shot, I have set the timeframe to five years. You can trace the stock's price (the black line), its normal valuation over that time period (blue line), and its relationship to FASTgraph's estimate of fair value, which it calls the earnings-justified value (orange line). As you can see, the stock's price has dropped below its earnings-justified price, and thus it might be considered undervalued at this time. That aligns with Morningstar's conclusion seen earlier.

Chuck's tool also provides other information. In this screenshot from lower on the same page, you can see J&J's recent dividend history, annual dividend growth rates, payout ratio by year, and its dividend return each year (expressed as a percent). At the bottom, the stock's total return (price + dividends) is shown in dollars and cents ("Closing Cash Value") and percent ("ROR" meaning rate of return).

Finally, let's look at the Dividend Champions document.

On this page, you can see J&J about in the middle. It has raised its dividends for 50 years consecutively, clear back to when I was in high school. You can see its yield as of the end of last month and lots of information on its most recent dividend increase. The yield shown is projected yield using the new dividend payout rate. The column labeled "Qtly Sch" is in code, but if you decode it you would get a shorthand look at J&J's typical schedule of dividend payments. There is no doubt that J&J has a managed dividend policy, what with its consistent dividend schedule and 50 years of dividend increases.

The final screenshot (above) from the Dividend Champions document shows a variety of DGRs for the company as well as the actual dividend payouts for the last 13 complete years through 2011. It's easy to see the clockwork regularity of J&J's annual increases. You may note that the DGRs fall as you shorten the time frame, meaning that the rate of growth of J&J's dividend has been slowing.

The slowing in J&J's annual dividend increases is clearly illustrated in Robert Alan Schwartz's dividend information site. In this screenshot, we see J&J's annual dividend, its annual increase, and its DGR to the end of 2011 calculated from the year in the left column. From both of the latter two columns, we note that J&J's rate of dividend increases has been slowing steadily for several years.

I'd like to mention that the Morningstar pages I showed here are all available for free, but that Morningstar offers a premium version that includes more information including their own analysts' report on every stock that they cover and the fair value that they have calculated for the stock. Chuck Carnevale's FASTgraphs is a subscription service that has caught on with many SA readers. David Fish's Dividend Champions document is free, as is Robert Alan Schwartz's website. Every one of these resources contains far more information than I have shown here.

Disclosure: I am long JNJ.