The natural inclination is to buy the stock with the highest yield, Sometimes it may be the best stock. Other times the high-yielding stock is the next in line to cut its dividend and/or see its price collapse. So how do find pick and choose between the alternatives to find the best available dividend stock?
Here is what I look for when buying a dividend growth stock for my long-term portfolio:
Sustainability
In this era of ultra-low interest rates, who wouldn't like to earn an 18% yield. An 18% yield would be outstanding! Unfortunately, an 18% yield is not sustainable. Companies simply can not generate enough cash to pay operating expenses, purchase capital, service debt, grow the business and afford to pay an 18% yield over the long-term.Often times when you see an 18% yield quoted, it is not really what it appears to be. When a company does not generate sufficient cash to maintain its dividend, over an extended period of time, but continues to pay the dividend, a portion of the dividend will be classified as a return of capital.
A return of capital is the payment of some or all of your investment in the company's stock. A return of capital reduces the basis of your stock. It is not a dividend - it just looks like one. Often the portion that is classified as return of capital is only disclosed at tax time, thus the full payment is used in calculating the dividend yield.
Strong Free Cash Flows
As an accountant, I can tell you our profession in its pursuit of theoretical perfection has adulterated the financial statements to the point that it has become very difficult for non-accountants to understand what’s behind the numbers.A dividend payout ratio is supposed to provide the investor with an indication of how much cash as a percent of earnings the company is paying its investors. A payout ratio based on GAAP net earnings could potentially have a lot of noise in it and not provide a clear picture of the economic condition of the business.
Instead of GAAP earnings, I prefer to focus on cash. Free Cash Flow has many definitions, but the one I use is operating cash flow less capital expenditures. Capital expenditures are deducted since you can’t run a business for any period of time without expending some level of capital.
These two numbers are easily located on the Statement of Cash Flows. This is the best snapshot of what cash the business has generated from “normal” operations and is available for dividends, debt, acquisitions and purchases of treasury stock.
To succeed as a dividend investor, you must find companies that can sustain and grow dividends by focusing on their ability to generate cash. I prefer a Free Cash Flow Payout of 60%, or less. You can fake earnings, but you can’t fake cash.
Low Debt
To gauge how levered a company is, the metric I like to look at is debt to total capital. Debt includes both long-term and short-term debt and is readily available on the liabilities side of the balance sheet.Total capital is a combination of debt and shareholders equity. When you divide debt by total capital a desirable rate is something less than 45%, but I will consider rates up to 50% on a short-term basis.
To find and buy dividend stocks that will continue to raise their dividends, it is not enough to only look at a company’s free cash flow. Many companies generate significant free cash flow, but the pertinent question is how much of the cash is already spoken for in the form of debt obligations.
NPV MMA Diff. Above Target
Even if a company can sustain and grow their dividend, is it the best option available? Would I be better off putting the money in a 20 Treasury, or another dividend growth stock. To answer these questions, I use my NPV MMA Differential calculation.A dividend stock's NPV MMA Differential is a hypothetical $1,000 investment in a stock and a Money Market Account (MMA) earning earning a 20 year average rate (I use a 20 year Treasury as a proxy). The value calculated is the net present value (NPV) of the difference between the dividend earnings of this investment and the interest income from the MMA over 20 years.
The calculation takes into account the time value of money, thus if it takes too long for the stock's dividend yield to exceed the MMA rate, then the calculation will return a negative value. This means you are financially better off to put your money in the MMA. If the dividend stock is a better investment then the NPV MMA Diff. calculated will be positive.
Similar to a stock's dividend yield, it is desirable to have a higher NPV MMA Diff. But also like a dividend yield, if it is too high, you need to start asking why? The NPV MMA Diff. can be used to compare two or more investments. Like all calculations, the value of the output is directly tied to the quality of the input (garbage in, garbage out).
Conclusion
The best dividend stocks are those that can sustain and grow their dividend. It is important to also consider the business outlook of the company being considered. This is one of the most difficult things to judge, but crucial in determining which company will still be growing their dividends 5 or 10 years in the future.Full Disclosure: n/a
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