How To Measure Quality Dividends?
Many dividend investors fall into the trap of lucrative dividend yields and form their investment thesis fully on the basis of this. This can have the pitfall of the company not being able to pay the generous dividends in the future and the dividend not to grow. Dividend growth is an important aspect on every investor who wish to benefit from the continuous passive income offered by the dividends.
Forward dividend yields are based on the expectations that the company could pay similar dividends in the future as they have paid out in the past. This would require that the business needs remain as profitable as in the past.
Many equity strategists have stated that the quality of the company could be best measured with the return on invested capital. In theory this should measure the level of quality of the business, since it measures the return that the company is getting from its investments. For me personally this and the return on equity are the best measures for a quality business: How much the company is making money for the shareholders and how successful investments the company is making. This should in theory also reflect to the capability of the company to grow their dividend.
Thus, I'm building a model that ranks the stocks in the Dow Jones Industrial Average according to their dividend yield and ROIC-%. The dividend yield is represented by the current dividend yield of the company and the ROIC-% is represented by the current estimation of the ROIC-% of the company.
When all the stocks are ranked we obtain the following matrix:
Two key observations can be made here. First of all, 3M (NYSE:MMM) and IBM (NYSE:IBM) seem to offer the best dividends for the investor according to this model. Current dividend yield for 3M is 3.26% with a ROIC-% of 22.76%. IBM's dividend yield currently is as high as 4.61% with a ROIC-% of 15.88%.
The shares of 3M are down -14% since January and the stock of IBM is up 24% on the same time. 3M would thus look like an interesting opportunity now.
Secondly, we can see that the energy companies Exxon (NYSE:XOM) and Chevron (NYSE:CVX) alongside Verizon (NYSE:VZ) and JPMorgan & Chase (NYSE:JPM) offer high dividend yields, but their ROIC-% would indicate that these dividends are relatively not high quality.
The most interesting observation is that the long-time dividend aristocrat Walmart (NYSE:WMT) is in the bottom of the group with a dividend yield of 1.85% and ROIC-% of 5.62%.
We can also observe that almost half of the stocks quoted in the Dow Jones Industrial Average have a ROIC-% of over 15%. Similarly, most of those stocks only offer a dividend yield lower than 3%. Dividend aristocrats such as Johnson&Johnson (NYSE:JNJ) and McDonald's (NYSE:MCD) fall into the category below the stocks that the model would consider to offer the dividends of the highest quality from the group.
When considering what would be the "next best group" depends on the investor. If you want to weight the future potential of the dividend, you would go with the groups offering the ROIC-% of over 15%. If however you weight the current dividend yield, you would go with the groups offering the highest dividend yield.
One must also consider the long-term figures from the model. ROIC-% can be considered to be relatively stable in the long-term, since it depends highly on the structures inside the particular industry and the company itself. The dividend yield on the other hand changes all the time according to the development of the stock and any changes made into the dividend pay-out policy in the company.
The model is a relatively simple one and it doesn't take into account any more company fundamentals in addition to these two figures. That is why this model can't be used as the only tool for stock picking. For quality and long-term prospects, investors might want to see the capital structures of these firms and the general outlooks of certain industries.
But I still believe that this model gives some ideas for the dividend investors who are weighing their options on different stocks. According to the model, 3M and IBM would offer the dividends of the highest quality from the Dow Jones Industrial Average.
Disclosure: I am/we are long CSCO, DIS, JNJ, JPM & NKE.