You should also calculate a company’s forward‑looking dividend payout ratio by dividing an average of analysts’ EPS estimates for the next fiscal year by its dividend. While a company may have a healthy dividend payout ratio now, you may be able to spot clouds on the horizon ahead if multiple analysts are forecasting a significant earnings decline in the coming quarters. If analysts were predicting that Wells Fargo’s earnings were going to drop by 50% over the next year to $2.04 per share (they’re not), its dividend payout ratio would rise to a much less healthy 74.5% and the continuation of its current dividend would be less of a sure thing.
The companies that you invest in as a dividend investor will generally have a relatively high dividend payout ratio. It only makes sense that companies that pay out strong dividends will pay out a significant portion of their earnings as dividends. Most of the companies that I personally invest in have dividend payout ratios between 40% and 70%. You should generally avoid companies that have a payout ratio higher than 75%, because there isn’t a lot of money left over to reinvest in the growth of the business and a short‑term earnings hiccup could force the company to cut its dividend. However, a very high payout ratio does not mean a company will automatically cut its dividend. Companies tend to be reluctant to cut their dividends and will sometimes borrow money or use retained earnings to pay their annual dividend during periods of weak earnings.
Real estate investment trusts (REITs), business development companies (BDCs), and master limited partnerships (MLPs) are the two exceptions to the suggested 75% dividend payout ratio limit. REITs and BDCs are required by law to pay out 90% of their income to shareholders in the form of dividend. Logically, REITs and BDCs will generally have dividend payout ratios that exceed 90% because of this rule. While MLPs do not have the same requirement to pay out 90% of their income as distributions, they tend to have strong cash flow but weak reported earnings due to the capital‑intensive nature of their businesses. Consequently, MLPs generally have very high reported dividend‑payout ratios.
When evaluating the sustainability of dividend payments for REITs and MLPs, calculate a company’s payout ratio based on its distributable cash flow rather than its reported earnings. Distributable cash flow is a measure of profitability that identifies how much money the company actually has to use for paying out dividends, reducing debt, investing in growth, or buying back its own shares. Distributable cash flow can be calculated by taking cash flow from operations minus capital expenditures, preferred dividends, debt service, and other one‑time items. By dividing a REIT or MLP’s dividend per share into its distributed cash flow per share, you can calculate a ratio that will provide a better idea of the sustainability of the company’s dividend.
Debt
Banks will rarely lend more money to people that are already deeply in debt, because they know that consumers that have a heavy debt burden are already paying out a large percentage of their income in debt payments and simply don’t have the cash flow to make payments on new debt. Likewise, publicly traded companies that have a large amount of debt are often limited in their ability to return capital to shareholders in the form of dividends because much of their cash flow goes toward making debt payments.
You can determine a publicly traded company’s debt burden by looking at its debt‑to‑equity ratio, which is simply the amount of debt the company has divided by the amount of shareholder equity. A debt‑to‑equity ratio of 1:1 is generally acceptable and any ratio lower than that is even better.
Debt‑to‑equity ratios will vary from industry to industry. In industries like telecommunications, manufacturing, and utilities, debt‑to‑equity ratios will be higher because companies in these industries use debt to finance long‑term, large‑scale projects. Companies in industries that have lower infrastructure requirements, such as consumer discretionary and consumer staples companies, will generally have lower debt‑to‑equity ratios. When evaluating a company’s debt‑to‑equity ratio, make sure to compare it to the debt‑to‑equity ratios of other companies in the same industry so that you are making a true apples‑to‑apples comparison of how much debt a company has compared to its competitors.
Profitability
A good way to determine whether or not a company will continue to have free cash flow to pay its dividend is by looking at the company’s net profit margins, which often gets shortened to “net margins.” Net margin is a metric that calculates the percentage of a company’s net revenue that is kept as profit. If a company has gross revenue of $1 billion and keeps $200 million as profit at the end of the year, it has a 20% net margin.
Companies that have higher net margins are able to weather economic turmoil easier than companies with lower net margins are able to because they can better temporarily weather periods of lower sales or higher expenses. For example, Buffalo Wild Wings (BWLD) has a net margin that hovers between 5% and 6%. If there was a major recession and the company had to lower the price of its menu items by 10% to attract new customers, the company would be losing money each quarter. BWLD competitor Dave and Busters (PLAY) currently has a net margin of about 12%. If it had to similarly discount its menu items by 10% for a period of time, it could still maintain its profitability. While neither BWLD nor PLAY currently pays a dividend, PLAY would be much better able to continue to pay a dividend during challenging economic times because it has higher profit margins than its competitor BWLD.
Profit margins will vary significantly from industry to industry, so there’s no hard‑and‑fast rule indicating what would be considered a healthy net margin for any given dividend stock. However, you should demand minimum net margins of at least 5% in the companies that you invest in because net margins can vary depending on current economic conditions. By requiring a minimum level of profitability, you can avoid relying on getting dividend payments from companies whose ability to generate profit during challenging economic conditions is in question.
Another way to measure a company’s profitability is return on equity (ROE), which can be calculated by dividing a company’s net income by the company’s shareholder equity. ROE shows the percentage of net income that a company is generating relative to the amount of money that shareholders have invested in the company. Companies that have a higher ROE percentage are more efficient in utilizing their shareholder equity to generate returns for their shareholders.
Generally speaking, analysts consider a 15–20% ROE percentage as good. ROE is particularly useful for comparing the profitability of multiple companies in the same industry. If you were considering investing in either Coke or Pepsi, you might compare their ROE percentages as a means of seeing which company is more profitable.
ROE is a metric that can fluctuate significantly from quarter to quarter, so a multi‑year average ROE might be a better tool for comparison than simply looking at the data for the most recent quarter.
TIP: You can easily look up a company’s historical debt‑to‑equity ratios, net margins, and return‑on‑equity numbers using YCharts.com. The easiest way to find the specific metric you are looking for is to do a Google search of the YCharts.com website. For example, if you wanted to find Apple’s net margins, you would do a Google search for “site:ycharts.com Apple net margins”.
Fair Value Estimate
There is an inverse correlation between a company’s share price and its dividend yield, which makes it especially important to pay attention to the ups and downs of the market and buy companies when they have been beat up a little bit, their share price is down, and their dividend yield is higher than usual. Some of the best buys that you will make as a dividend investor will occur when an otherwise good company’s share price is getting hammered over short‑term bad news, such as weak earnings or a major lawsuit.
Cummins (CMI), a major diesel engine manufacturer, saw its share price drop from $120.00 in September 2015, to a low of around $83.50 in January 2016 after seeing a year‑over‑year decline in revenue. I thought Cummins was fundamentally a good compan
y, given that it makes a sizable portion of the world’s diesel engines, and that the stock was oversold. I bought shares of the company at $86.37 and was able to lock in a yield of 4.75%. In the seven months that followed my purchase, the company’s share price rose back up to around $125.00 and its dividend yield dropped down to 3.25%. Because I was fortunate enough to purchase the stock when its share price was depressed, I was able to lock in a yield much higher than Cummins investors are able to get today and had the added benefit of price appreciation in the shares I bought.
My favorite tool to determine where a company is trading relative to its intrinsic value is Morningstar’s (www.morningstar.com) proprietary fair value estimates. Morningstar’s analysts issue estimates of what they think any given stock should currently be priced at given the company’s financials, long term prospects, economic moat, and other factors. Fair value estimates attempt to strip away the irrationality of the market and provide a general idea of what a stock should be priced at so that you know whether or not you are overpaying for a stock. Morningstar’s fair value estimates are far from a perfect metric, because all equities research analysts are fallible, but they can provide a helpful idea whether or not a stock has been overbought or oversold.
You do need a Morningstar premium account or a subscription to Morningstar Dividend Investor to look up fair value estimates. Morningstar premium subscriptions are currently sold for $23.95 per month or $199.00 per year. More information about Morningstar’s premium subscription offerings can be found at http://members.morningstar.com/.
Another way that you can determine whether or not a dividend stock is a currently a good buy is by looking at a chart of the company’s dividend yield over time. By looking at a graphic representation of the company’s annual dividend relative to its share price over a period of several years, you can easily see whether the company’s dividend is currently higher or lower than its historical average. You can use the website Dividend.com to chart a company’s dividend yield over time by entering in the name of any publicly traded company in their search box. On the Dividend.com’s information page for the company you are searching for, scroll down to the section titled “Dividend Yield & Stock Price History” and click on the “Yield” link in the chart legend to view a chart of the company’s dividend yield over time.
Using Dividend Discount Model to Develop a Fair Value Estimate
Dividend discount models (DDMs) attempt to identify a fair price for a stock based on the expected future dividends that shareholders will receive. DDMs generally assume that the only real value that stocks provide to shareholders is the dividend stream that the companies produce.
The theory is that capital gains and volatility in share price is the result of investors adjusting their expectations for a company’s future stream of dividend income. DDMs attempt to project the value of all future dividends and then discount them to a net present value that identifies a fair value for the company’s current share price. By using a DDM calculation, you can identify whether or not a company is currently trading above or below its intrinsic value.
Many investors use this simplified dividend discount model:
Expected Share Price = Annual Dividend / (Cost of Equity – Dividend‑Growth Rate)
This equation involves taking the company’s annual dividend and dividing it by the cost of the company’s equity minus the company’s expected long‑term growth rate. For example, Realty Income Corp (O) currently pays an annual dividend of $2.42 per year. If we use 10% as our cost of equity and expect Reality Income Corp’s dividend to grow by 6% per year over the long term, the DDM above would suggest a fair price for the stock would be $60.50 ($2.42 / (.10 - .06)).
This simplified form of a dividend discount model can be helpful in identifying a fair price to pay for a stock, but we should be cautious about how much attention we pay to DDM calculations. The equation above assumes that the company’s dividend‑growth rate will never change and that the company’s cost of equity will also never change.
We may also not have a good idea of what the company’s cost of capital actually is and what the company’s long‑term average annual dividend‑growth rate will be. Because this equation only uses three inputs, it is very easy to calculate, but the results of the equation are very sensitive to the numbers you use. For example, changing Realty Income Corp’s long‑term dividend‑growth rate to 7% would raise its fair value to $80.67 (33% higher than the fair value calculated using a 6% long‑term growth rate).
Economic Moats
In medieval times, a moat was a body of water that surrounded a castle in order to keep out potential invaders. In the modern era, an economic moat describes certain advantages that some companies have that allow them to stay ahead of the competition. The larger the moat a company has, the more likely that it will continue to be a profitable and viable business in the years to come.
There are several types of competitive advantages that can create an economic moat for a company:
Barriers to Entry – Some industries have high financial or regulatory barriers to entry that would make it extremely difficult for new competitors to enter the market. For example, it would be almost impossible to create a new railroad network in the United States because of the thousands of tracts of land that would need to be bought from private‑property owners. The four major players in the space (Union Pacific, BNSF, CSX, and Norfolk Southern) have huge economic moats simply because there are unlikely to be any new rail lines in the United States. In order to unseat the four major railways, an entirely new transportation method that is cost‑competitive with rail would need to be invented.
Brand Name – Consumers are naturally more likely to buy products and services from a brand that they are already familiar with than one that they have never heard of. Many companies have tried to make soft drinks that taste better than Coca‑Cola, but none has been able to unseat Coca‑Cola as the world’s dominant soft‑drink producer because the Coca‑Cola brand is so ingrained in the minds of consumers. Having a strong brand name also allows Coca‑Cola to maintain pricing power over its competitors. You can buy a can of generic cola for $0.25 in a grocery store, but you are two to three times more likely to get the brand of soft drink that you are familiar with and already know you enjoy.
Economies of Scale – Companies that produce, transport, and sell goods at larger scale than their competitors can often benefit from reduced costs that their competitor can’t match. Wal‑Mart (WMT) is the perfect example of a company that benefits from having economies of scale. Because they have more than 4,000 stores in the United States and sell nearly $500 billion per year in annual revenue, they can purchase goods from suppliers more cheaply than their smaller competitors can. This allows them to sell goods at lower prices while earning higher profit margins than smaller competitors do.
High Switching Costs – If it takes a significant amount of time, money, or effort for a customer to switch from one company or another, customers are much less likely to move their business elsewhere. High switching costs insulate an existing company from upstart competitors because it will be difficult for the new company to steal the existing company’s customers. For example, people rarely switch banks because it takes a lot of work to set up new accounts, update their direct‑deposit records, change payment methods for recurring subscriptions, and move their money over. Even if you’re unhappy with your current bank, it’s just easier to stay where you are because of the amount of work involved with switching to another bank.
Other Intangible Assets – Some companies benefit from patents and trademarks that prevent companies from making similar or identical products. For example, prescription‑drug companies that patent a new medicine will receive the right to be the exclusive seller of that medicine for 17 years from the date of the patent. Drug patents allow prescription‑drug companies to set whatever price they choose for a new drug without fear of being undercut by another competitor for nearly two decades. Likewise, trademarks t
hat make it into our everyday vernacular also make it difficult for other companies to compete. For example, no one can make a facial tissue called Kleenex® besides Kimberly Clark and no one can create cotton swabs called Q‑Tips® besides Unilever.
Economic moats can sometimes be difficult to quantify or assign an economic value to, but having any of these competitive advantages is preferable to not having them at all. Morningstar has attempted to create a system that ranks a public company’s economic moat as wide (strong), narrow (weak), or non‑existent. I generally take Morningstar’s economic moat ratings with a grain of salt, but they can be a helpful indicator of whether or not a company has any meaningful competitive advantages.
Dividend Analysis Example: Verizon Wireless
In this chapter, we have looked at a number of quantitative and qualitative metrics that we can use to determine whether or not any given dividend stock is attractive. We will now take these newly acquired analytical skills and use them to evaluate a couple of publicly traded companies. Let’s start with Verizon (VZ). The company currently pays a dividend yield of 4.27%, which is well within the 3.5–6.5% range that I target. The company has raised its dividend for nine years in a row, which is not quite the 10‑year track record that I look for, but is close enough for all intents and purposes. The company has only raised its dividend by an average of 3.2% per year over the last three years, which does not meet the 5–10% annual dividend‑growth guideline I target. The company has a healthy payout ratio of about 64%, which is under the 75% maximum payout ratio that I target.
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