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Wednesday, November 2, 2011

How to Analyze a Dividend Stock

I recently wrote an article for the Investment Underground (Click Here) in which I provided recommendations on five dividend stocks and a justification for each recommendation. When you analyze so many similar stocks one right after another you tend to find a system and a rhythm. The first stock might require 3 hours or more to really feel comfortable before making a call. The next may go faster since you have identified where to find the information you seek already and have another set of stocks (the first stock and competitors) in which to compare. By the fifth stock (which actually means you have looked at 20 or so) the system is tight and you can see the patterns and make the calls in 30-45 minutes.

Since I have been there and done that, I figured I would share. Here is my system for analyzing dividend stocks. I am not suggesting that there won't be a learning curve. Don't expect to make a call on a stock in the same amount of time it takes you to watch an old episode of Wonder Years on Netflix (Ticker Symbol: NFLX) but you should be able to decide whether or not a stock is worth putting on your watchlist and whether you should do a bit more homework on it.

The obvious place to start is at the dividend yield. For those new to the world of dividend investing the yield is calculated by taking the annual dividend distribution and dividing it by the current stock price. If you are scared of math you may have stumbled into the wrong hobby but don't fret. This value is given to you free of charge at nearly every finance website. I prefer Yahoo!

Determining what size dividend yield you want is a personal choice. I will leave that part up to you. I am going to focus on the actual analysis of the stock in question but it is important to know what the dividend yield is so we can compare it to what it was and what it could be in the future.

Knowing what the yield right now doesn't do you much good if the dividend might vanish or be reduced next quarter. To ensure that doesn't happen you have to determine the dividend's sustainability. This is primarily a question of the company's overall financial health. To get a handle on that you should look at the following key statistics;

Earnings - Like any stock evaluation, you want to see positive and improving earnings. The more the company makes on the bottom line the more they can potentially distribute to their shareholders.
Cash - A healthy cash reserve will allow the company to sustain the dividend even if they have a few rough quarters. I like to see a cash reserve that is no less than 1/4 the amount of debt a company holds. This ratio is somewhat arbitrary and may not be appropriate for all industries but it is an indication that the company can handle it's debt load and can cut interest expense by paying down debt quickly. That flexibility is very attractive.
Operating Cash Flows - This is another number that should be compared to the amount of debt a company holds. Again, I would like to see a 1/4 ratio of operating cash flow to debt. As stated above, This shows the ability (though not the intent) of a company to pay down debt to ensure that interest expense does not eat away at profits.
Debt - As long as the comparison of cash and operating cash flows and debt stay reasonable everything looks OK. When a company's earnings can't support the dividend and the company starts borrowing to pay their dividend there is cause for concern.
Payout Ratio - The payout ratio shows how much of a company's earnings go towards dividend distributions. In general, the lower the number, the better. However, a number below say, 15% may be an indication of the company's lack of conviction regarding returning cash to its shareholders. This may warrant additional investigation into the company's philosophy on dividend distributions. If the company can afford to provide more cash to the shareholder, why isn't it? A number above 90% may mean that the company isn't earning enough to sustain the dividend at its current yield.

Once you are reasonably sure that a company can afford to continue to provide a dividend the next step is to check on the consistency of that dividend. Poor financial health isn't the only reason a dividend stock might decide to reduce or eliminate its dividend. Often a yield will be affected in the short term by a steep reduction in stock price. Whether or not that stock price change is justified does not really matter. The company may have a specific target for it's dividend yield and may adjust the distribution lower to account for the change in stock price. To get a feel for the dividend's consistency look at the following information;

Distributions over the past 5 years - This information can be quickly retrieved through Yahoo! Finance. Simply go to the stock's summary page by typing in the ticker symbol in the search bar and clicking "Get Quotes". Along the left side of the page click "Historical Prices". Toggle to "Dividends Only" and viola. Here you want to see a reasonable progression upward which would indicate distribution growth. If you see wild distribution changes the company may be adjusting in consideration of stock price, earnings, seasonal trends or on a whim. Regardless, unpredictability is not an attractive trait in a dividend stock.
Earnings Call transcripts - I like to search the earnings call transcripts for the word "dividend" to see what the company has to say about their intentions regarding the dividend.
10-K and 10-Q reports- You can also do a search on these annual and quarterly SEC filings to identify the comapny's philosophy on dividend distributions.

Now that sustainability and consistency have been checked it is time to look at dividend growth prospects. At this point you have already looked at the statements regarding dividend distributions in both the SEC filings and the conference call transcripts. You should have a decent grasp of whether the company is satisfied with its current distribution and yield but if they were mum on the subject you can look at thier ability to grow the distribution and make your own decision. To do this we consider some of the same information that we have already collected; payout ratio, cash, debt, operating cash flow. I like to compare these numbers to that of there nearest competitors. For instance, if I wanted to look at Coca Cola Company (Ticker Symbol: KO), I would also look at Pepsico Inc (PEP) and Dr Pepper Snapple Group (DPS). Comparative analysis is an important part of any first quick turn around analysis because it provides context and a jumping off point. Things to consider;

Who is the industry leader? - The leader may not provide as big a dividend as the 2nd and 3rd ranked company because they don't need to do so to attract investors. They often have a slightly higher P/E as well.
Who has greater growth prospects? The industry leader may not grow as fast as the smaller, younger companies and may compensate for a stagnant stock price with an increased dividend yield. Likewise, companies with greater growth prospects will have to spend money instead of distributing it as a dividend to achieve that growth.
Which comapny appears to be operating more efficiently - Companies that are more mature tend to operate more efficiently and can therefore afford to provide a higher dividend yield with less impact to there bottom line. Compare return on equity (ROE), return on assets (ROA) and return on investment (ROI) for an indication of a company's efficiency.

This is not an all inclusive analysis and more homework needs to be done. However, I did provide a great base for your analysis that may speed things up. Chances are you will rule more out quickly with this system and that is a good thing. A thorough end-to-end analysis should be done prior to making any buying decisions. I hope you found this article helpful. Thanks for reading.


  1. Your article very helpful. Thank you for your information

  2. I appreciate the feedback. If you have any questions please feel free to post them in the comments. I would be happy to answer them.