Considerations in Evaluating a Dividend Stock – Summary and Recommended Resource
An investor needs to consider many factors before investing in a dividend stock. At a high level, there are three main considerations:
Earnings - Dividends that are not supported by earnings won’t be paid for long. The earnings history, both recent and extending back as much as ten years, must be reviewed to determine the stability of earnings and earnings growth. The dividend payout ratio is a key statistic. While acceptable ranges vary by sector, a ratio over 100%, or even close spells trouble. (Note that for Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs), different metrics than Generally Accepted Accounting Principles (GAAP) earnings should be used to determine safe payout levels.) Besides the numbers, consider subjective factors, such as the concept of whether the company has a protective “moat”, which in investment terminology refers to how vulnerable the company is to having earnings depressed by new, stiff competition. What about macro trends, such as demographics – are there identifiable trends that might impact future earnings? There are many items to consider when evaluating the safety of earnings.
Debt – Keep in mind that the common stock shareholder is “last in line” to get paid out of company resources. Examine the debt level and the various debt ratios, such as debt/equity, interest coverage, and the overall leverage ratio. Although some debt is normal and reasonable for the typical corporation today, outsized debt levels compared to peers in the same sector is a red flag. During the financial crisis, manageable debt levels quickly became unmanageable when credit froze up and debt rollovers became impossible to achieve.
Commitment – This is the most difficult of the three main considerations to evaluate, since there are no metrics available to aid in the evaluation, other than the dividend history. Of course, the history can be very revealing of management’s commitment, at least in the past. If a company has a long history of regular, steadily-increasing dividends, you can be pretty well assured that they will continue in the absence of financial duress. The review of earnings and debt levels should indicate how likely it is that the company can meet the dividend commitment, assuming the business continues to perform. (If the business does not continue to perform, commitment or not, the dividend is likely to become a casualty, if things aren’t turned around.) One additional characteristic that I consider is the company’s website. If the company’s management is proud of their status as a dividend payer, the website should feature the dividend information prominently. If you can’t find any dividend information, it might mean dividends are not a priority.
An advisory service that I have found very helpful for the dividend investor is the Morningstar Dividend Investor. The introductory materials you receive as a new subscriber contain a thorough review of the process of identifying and vetting dividend stocks. If you don’t want to commit to a subscription right now, the newsletter editor has authored a book which expands upon the topic and covers just about everything a dividend investor needs to know. The book is entitled “The Ultimate Dividend Playbook”, by Josh Peters. The book is available in many if not most bookstores, and is also available from Amazon.
Disclosure: I have no affiliation with Morningstar or The Dividend Investor. I am a subscriber only.