Wednesday, March 2, 2011

My Entry Criteria for Dividend Stocks

There are thousands of stocks traded on US and international markets. If one were to analyze in detail all of these stocks it would probably take them a lifetime to accomplish this task. Luckily, dividend growth investors have several lists they could use to aide in the search for quality dividend stocks.

The first criterion that I use is that a company must have consistently raised distributions for at least ten years in a row. According to the dividend champions list, maintained by Dave Fish, there were 234 companies trading in the US which have managed to accomplish this. The reason behind requiring at least a decade of consistent dividend growth is to weed out all companies which are inconsistent in their dividend policies.

The second criterion includes removing companies which trade at a price/earnings ratio that is above 20. Even the best dividend paying companies such as Coca-Cola (KO) or Procter & Gamble (PG) are not worth buying at any price. In fact it could be argued that the reason behind the lackluster performance of the US Stock Market and many dividend stocks over the past decade is because they were grossly overvalued in the early 2000s. Despite the fact that many of these companies were able to substantially increase earnings and dividends over the past decade, these stocks are only now beginning to appear attractively valued. The only returns these shareholders were able to generate over the past decade were mostly from dividends.

The third criterion includes removing all stocks whose dividend payout ratio is higher than 60%. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings. Otherwise a high payout could show that the company cannot afford to pay the distribution and that the risk of a dividend cut is high.

Next, I want to look at earnings growth over the past decade, and dividend growth that exceeds inflation over the past decade.We want companies that grow earnings per share. This provides fuel for future dividend increases and increases the likelihood that the intrinsic value of the business grows over time.

After applying the set of criteria described above, the dividend investor should have a more manageable list for further research. While some investors also use dividend growth as another criterion, I typically want to only see it in the positive territory. The individual dividend growth is dependent on the type of company in the dividend yield and growth trade-off. After that I evaluate dividend growth prospects on a company by company basis. In addition, certain companies which pass-through most of their income to shareholders such as REITs and MLPs should be evaluated using a separate set of criteria that fits better with the type of business structure investors are analyzing.

It is important to remember that dividend investing should not be seen as a mechanical process. Investors should further analyze in detail the companies which their list generates and evaluate their competitive advantages, understand their business model and decide for themselves whether future dividend growth could be maintained.

Full Disclosure: Long PEP,PG,KO, WMT, MCD, CVX, CL

Relevant Articles:

- The ten year dividend growth requirement
- The Sweet Spot of Dividend Investing
- Buy and hold dividend investing is not dead
- The Future for Dividend Investors

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