This article was published in the May 2014 edition of the Canadian MoneySaver, and is posted here with permission. For more information visit canadianmoneysaver.ca
Although dividend investing can seem overwhelming and complicated, it really doesn't need to be. Nor do you need to be a financial professional or CPA to make sense of it all. A few red-flags to watch out for, as well as specific ratios to look at, will help you buy a dividend titan instead of a dividend dud.
Here are four key dividend metrics I look at, when initially screening dividend stocks:
The dividend yield is probably the easiest metric, and the first place to look. I want to invest in companies that are paying me a reasonable dividend yield for being a shareholder.
The Ninja's rule of thumb is:
- A large-cap should never pay more than a 5% dividend yield.
- A small-cap should never pay more than a 7% dividend yield.
- A company with a 10%+ yield is a speculative investment.
If you are drawn to a high-yield stock, then think twice. Usually that high-yield comes along with a crashing share price, and declining sales or earnings. More often than not these companies carry high debt. I covered The Lure and Dangers of High-yield Stocks, in the February and March 2013 issues of Canadian MoneySaver.
Conversely, stocks with a dividend yield lower than 2.5%, don't pay me enough income. Resource companies usually fit into this category. However, lower yield stocks can offer more potential for capital appreciation. These companies also have more room for dividend growth, so don't completely discount them.
As a dividend investor I'm primarily investing for income. If a company doesn't pay a dividend at all, then I'm not interested. In this case I would be solely relying on capital appreciation, assuming the stock appreciates. This quickly screens out high-flying IPOs like Twitter (NYSE:TWTR) and Facebook (NASDAQ:FB), which are best left for traders.
Dividend Payout Ratio
Hand in hand with dividend yield, is the Dividend Payout Ratio (DPR). I covered this metric in the July/August 2011 issue of Canadian MoneySaver.
The dividend payout ratio is very easy to calculate. The key figures you need are EPS (earnings per share) and the dollar amount of the Annual Dividend.
Dividend Payout Ratio = (Annual Dividend / EPS) * 100
The Dividend Payout Ratio indicates how much of a company's revenue goes into paying out its dividend to shareholders. For example, a company with a Dividend Payout Ratio of 60%, would pay out 60% of its earnings as dividends to shareholders, while retaining the other 40%.
Investors consider 30% to 60% as the ideal Dividend Payout Ratio. Dividend investors like to purchase stocks within this range as there is also room in the company for future growth, and dividend increases. Companies with high payout ratios usually have other systemic problems. They will be unable to raise their dividend, and may even suspend or cut it.
Many small-cap companies base their payout ratio on cash flow instead of earnings. Most of the previous Income Trusts, REITs, MLPs, and junior oil and gas producers use distributable cash flow and not EPS. I covered this in What Happened to the Income Trusts? Part-2, in the November 2011 Canadian MoneySaver. These kinds of companies require much more due diligence. Other than REITs, I generally stay away from them.
Debt to Equity Ratio
If a company has a high payout ratio, chances are it also has a high debt load. Other than established telecoms, pipelines, and utilities, companies carrying high debt usually get into trouble. They don't have the cash reserves to whether economic cycles, and become more susceptible to short-term trends. A company that must continually pay down its debt obligations, or keep borrowing, seldom has the room to expand its business. It certainly won't be raising the dividend. If a company in debt runs into trouble, you can assume the next sign of trouble will be a suspended or cut dividend.
A simple metric for evaluating company debt is the Debt to Equity ratio. This ratio is found under the Key Statistics page in Yahoo Finance. The lower this number the better. However, the debt to equity ratio tends to be industry specific, as some companies require leverage to fund operations and growth (i.e. utilities and telecoms). So you do need to do a quick comparison of a company to its peers. As a general rule of thumb, other than utilities, if the debt to equity ratio is over 70% then consider looking elsewhere.
A profitable company will generally stay out of debt, pay me a reasonable dividend, and grow that dividend over time.
An indicator of profitability is the Net Profit Margin (net income/sales). This ratio can also be found under the Key Statistics page on Yahoo Finance. As with the debt to equity ratio, it tends to be industry specific. So you need to compare the ratio for a company among its peers. However as a general rule of thumb, I usually invest in companies with a net profit margin of 15% or higher. Companies with a net profit margin of 5% or lower are problematic and should be avoided.
Take Staples Inc. (NASDAQ:SPLS) as an example, which I bought in August 2011, then later sold. Here is a 8.7 billion dollar company that is well managed, has low debt, and a solid dividend yield. It is also a company that raises its dividend every few years. So it fits all the basic criteria.
However, it also has a razor thin profit margin of only 2.03%. Sure enough, quarter after quarter Staples missed earnings estimates. Its share price has been quite volatile, and is trading with lower-highs and lower-lows. Think about it. If a company only makes 2 cents on the dollar, but is paying a 3.6% dividend, then where is the money coming from?
The bottom line is, if a company does not have a healthy profit margin, then move onto the next stock.
When conducting your initial screening for dividend stocks, these are the most basic screening criteria to consider. If any one of these is a red-flag, then drop the stock. You'll likely run into problems later. Sometimes a bargain is just a bargain, and a value play can quickly turn into a value trap.
Even if a company meets these basic criteria, I then dig further into the company's earnings and historical dividend growth. Dividend growth is considered by dividend investors to be one of the most important metrics. Many investors won't even touch a company without a dividend growth record. It's an in depth topic, so I'll cover Earnings and Dividend Growth in a future issue.