As you all can see, Lanny has been littering our blog with posts. I figured it was about time I threw an article out so you all can hear from someone else. This article will discuss a few basic metrics that Lanny and I use while screening for potentially under-valued dividend stocks. The metrics are just the tip of the iceberg, as the investing requires a lot more research. But throughout my investing experience, I have found it very helpful to have a consistent set of metrics while performing the initial stock screening.
Metric #1 P/E Ratio Less than the S&P 500. Price to earnings is well documented as a quick metric to identify stocks that may potentially be undervalued. We use this to identify stocks that may be discounted compared to the overall stock market. The current stock market PE is 18.74 (as of 5/18/14), so I set my screener at a PE of <15 to identify stocks that offer a pretty decent discount from the market. This is not the only way I use PE though, as you really need industry comparisons to unlock the value of the metric. Once a stock is identified, I compare the stock’s PE to their competitors to provide an apples to apples comparison. The <15 metric just helps me identify the companies.
Metric #2 Payout Ratio of Less than 60%. Can a business sustain a business model that uses all (or the majority) of their earnings to pay shareholders a dividend? We do not believe so. There is a healthy balance of rewarding shareholders and re-investing profits in the company. Through research, reading article, reading books, etc., we believe a Payout Ratio of <60% is a healthy ratio that will allow a company to sustain its current dividend. I love finding companies that have payout ratios well below our 60% benchmark (<30%). This shows the company has a lot of room to grow their dividend in future periods. Couple a very low payout ratio with a large Cash/Share total and I begin to salivate at a future large dividend increase. conversely, if a dividend ratio spikes above 60%, the stock’s current dividend may be in some serious trouble for the reasons mention at the beginning of the paragraph. (Sidenote: Our other dividend diplomat, Lanny, successfully identified the decrease in FirstEnergy‘s dividend earlier in the year using this metric. I believe their payout ratio at the time of the decrease was above 100%. I thought he was crazy at the time since I thought a utility company would never decrease their dividend, but I was wrong. )
Metric #3 Increasing Dividends. It is important for our portfolios to invest in stocks that continue to grow their dividend. If a company issues a stagnant dividend, the yield has the potential to decrease if the stock suddenly has a period of strong price appreciation. In addition, increasing dividends is a signal of strong financial performance by the company as more dollars become available to shareholders. Lastly, who doesn’t love an investment that historically raises their return to shareholders? It provides a nice little increase to their annual income. Ideally, I would like to see a company grow their dividend at a rate greater than inflation to avoid losing purchasing power on future dollars. However, the growth rate greater than inflation is not the end-all be-all for me as I own several stocks in my portfolio (T, FE) that do not follow this.
I recently used the metrics to purchase Dow Chemical (DOW) in April. I use finviz.com as my screener since you can save a preset stock screen and the format is really easy to follow. My screener is run once or twice a week so I can get a general understanding of what stocks are regulars in the “Below 15 PE club” and I can easily identify if a new stock suddenly becomes discounted. this helped me identify that DOW had become discounted from its earlier levels. My analysis showed that DOW had a lower PE Ratio compared to its peers, that DOW had a dividend yield of 3%, that DOW had a Payout Ratio less than 60% (31% to date), and has raised its dividend well in excess of the inflation rate (Average increase of 36% since DOW decreased their dividend after the financial crisis). Once DOW passed the screener, the boring part of the research began (reading 10ks, earnings calls, etc.) and eventually I decided to initiate a position in the company. Currently, my investment in DOW will yield me $50.32 in annual dividends and my investment has returned me 1.44% since inception.
Again, the metrics are just the tip of the iceberg in the decision-making process. What metrics do you use while screening for stocks? Any comments or suggestions for my screener?
Enjoy your Sunday!
Note: The values used in this article are as of 5/18/14 and are subject to change once the market opens on 5/19/14