THE ART OF THE DIVIDEND PART ONE

There are thousands of stocks listed on the markets, and many of them pay dividends of various amounts and frequencies.  To invest in dividend stocks, the first step is to develop a method of screening through lists of candidate stocks to select the ones that would be fitting for a portfolio.  A good on-line broker will provide tools that list dividend paying stocks using filters to select the ones with the criteria that suits the needs.  Then the list should be culled, eliminating stocks that don’t qualify for other reasons. 

The culling process includes a fundamental evaluation that tells how well the company measures up financially.  This becomes more important for dividend stocks than for other stock strategies because the financial health of the company parlays into its ability to pay dividends.  This fundamental evaluation should include, but not always limited to, the following criteria.

Company Profile/Business Summary:  Reviewing the company’s business summary in the profile section will tell in reasonable detail what the company does to make their money.  It provides a stop-or-go signal in that certain industries and sectors should be avoided at certain times.  A close look is also important in that the company’s business activity might be on the fringe of the sector, and those economic conditions that apply to the sector might not apply specifically to the selected company. 

Earnings per share:  Checking the earnings per share forecasts versus the actuals will show if the company provides enough advanced information to analysts to render good earnings forecasts.  If forecasted earnings are close to the actuals, it’s a point in the company’s favor.  However, some industries are easier to forecast than others, but the ones that have more accurate forecasts generally have dividend returns that are easier to predict.  If a company’s forecasted EPS is way off its actuals, there may be a credibility issue in that company might be providing rosy financial data to attract more investors.  The trend of EPS should also be observed in light of overall economic trends.

Income statement:  The income statement shows profit and loss, and should be checked to see if the company is a good earner.  Companies that have huge dividend yields but don’t earn that much on a regular basis could have dividend problems down the road.  The trends are also important as a strong downward revenue and/or profit trend could foretell cuts to the dividend. 

Cash flow statement:  The cash flow from operations on the cash flow statement should always be compared with the total operating income on the income statement.  The cash flow should be greater than the operating income as the income is often reduced by non-cash write offs such as depreciation and/or amortization of certain assets.  It’s important that the company has a strong cash flow coming in at the operating level as this would show less tendency for the company to be constantly needing short term loans to keep the business going.  There can be minor exceptions to this rule if the trends look favorable for the future.  But if the company can’t generate enough cash from its operations to keep the business going, it’s unlikely they can continue to pay a dividend for very long.

Balance sheet:  The most crucial balance sheet aspect to check is the debt/equity ratio.  There is no rule of thumb here as to what a good debt/equity ratio should be, but if the debt is drowning the equity and trending higher, it could mean an end to dividends is on the horizon. 

Dividends are paid out of the retained earnings account.  The trend of retained earnings is thereby important although the sector and/or industry that the stock is in could mitigate what would appear to be a bad trend.  Real Estate Investment Trusts and Master Limited Partnerships by law must return most or all of their net incomes to shareholders in the form of dividends.  These companies will often show a negative retained earnings balance but still are able to maintain their yields.  A severely bad retained earnings trend in most other cases could mean the end of future dividends. 

The amount of treasury stock in the equity section should be noted as it consists of buybacks the company has made, but has not removed from their books.  Buybacks are generally considered to be a form of shareholder return, but if they are excessive in amount, they could impact future dividend decisions.  It’s important to insure that any treasury stock could be retired against retained earnings, and that there would still be ample retained earnings left for dividends.

Price/Earnings ratio:  The current price divided by trailing earnings per share (those earnings that have already taken place) gives a good look at a stock’s valuation especially when compared to the sector or market index.  The P/E ratio only has meaning in a comparison—there is no general standard that can apply.  It’s also hard to compare the P/E’s of companies across different sectors as some industries (especially technology) have P/E’s that are higher generally speaking than other sectors (especially finance).  A below average P/E tells you that the stock’s price is lower than it should be for the earnings that the company generates and is thereby considered undervalued.

Dividends Regularity:  Check to see if a stock candidate pays regular dividends and if there is an element of dividend growth over the last decade or so.  The dividend payout ratio and the dividend coverage ratio can serve to support whether the company can continue paying the current rate of dividends, or if any future shock to earnings or cash flow happens, the dividends would be reduced. 

Summary:  Good fundamental analysis should be done before investing in dividends and should be repeated periodically after buying a position to see if any adverse changes have taken place.  All the above tests do not necessarily need to be passed by a company before investing.  Once the candidate list is culled, it becomes a watch list, and is used in achieving a good entry point for dividend positions.  I will discuss that further in the next blog.