Lanny and I use a basic stock screener to help identify undervalued dividend growth stocks. We have found it very helpful to have a consistent set of metrics to apply to all stocks. Once a stock passes the screener stage, we begin to roll up the sleeves and perform detailed stock analysis. Our three metrics are as follows:
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 S&P P/E ratio is currently between 18-19 on any giver day, 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.
Examples of Applying the Stock Screener:
The following are links to articles in which we have applied the stock screener to various companies. For a few, the application of the screener has helped sway us to initiate a position in the company.
DISCLAIMER: WE DO NOT RECOMMEND ANY DECISION TO THE READER or ANY USER, PLEASE CONSULT YOUR OWN RESEARCH. THANK YOU FOR YOUR UNDERSTANDING.