What I Look for in a Dividend Growth Stock

Contributed by Dave Van Knapp

I am a Dividend Growth (DG) investor, and I want to explain what I look for in selecting DG stocks.

I run my investing like a business. This is my business model as a DG investor:

Identify, accumulate, and manage a portfolio of DG stocks that reliably send growing amounts of cash to headquarters. 

Headquarters is my desk upstairs. 

A DG investor is a holding company. We buy and own pieces of outstanding companies that send rising dividends to their owners.  

A core competency needed to run a successful DG business is to be able to pick companies that suit your goals. No matter what your specific goals are, you will want companies that are proficient at making money, likely to do so for many years, and have a strong predictability of increasing their dividends regularly. 

How do you find such companies? That’s what we are going to talk about. Each section of this article explains a factor that I investigate before buying any stock. 

Initial Yield

Yield is the one-year percentage return on your investment from the dividends that the company sends to you.

Here is how Simply Safe Dividends™ displays yield. The example stock is PepsiCo (PEP), which I will use throughout this article for illustrations. (Disclosure: I own PEP.)
Source: Simply Safe Dividends
I check yield for its size. Among dividend investors, there is a spectrum of yield requirements. 

Some – who are often young and mainly interested in growth prospects – gravitate towards lower-yielding stocks with fast growth rates.  

Others, more interested in collecting income right away, or in building a “dividend factory” over the long term, might require certain minimum yields. 

I usually require a minimum 2.7% yield in the stocks that I buy. With risk-free interest rates above 4% these days, my preference lately is to get initial yields of 3.5% or more.

Yield varies inversely with price, because the formula for yield has price in the denominator.

Yield % = One year’s worth of dividends ÷ Current share price

Obviously, when the stock’s price goes up, its yield goes down, and vice-versa. That is why, when the market is broadly down, good-yielding stocks are easier to find. And when it is broadly up, stocks with sufficient yields become harder to find. 

Dividend Growth Rate

Dividend growth rate (DGR) is the speed at which a company has been raising its dividend each year. 

DGR statistics look backwards. You will not know the size of a company’s next increase until the company declares it.

Here is how Simply Safe Dividends™ displays Pepsi’s dividend growth. 
Source: Simply Safe Dividends
There is a wealth of information in this presentation:

  • Most recent increase.
  • DGRs for the past 5 and 20 years. (These are compound annual growth rates for each time period.)
  • Visual graphic depiction of the annual increases. 
  • Length of the growth streak. 

I require at least a 5-year streak to consider a stock for purchase. Pepsi has increased its dividend every year for 50 years in a row. 

I think 4% dividend growth per year is OK for a high-yielder. DGRs in the 5-8% range are fine for mid-yielders, and 10% per year is excellent for most any stock. 

I also look at the growth trend. I do not like to see a pattern where the DGR has been continually declining. Pepsi’s graph shows that its increases have been pretty steady over the years.

You will not find many stocks with both a high yield and fast growth rate. Low-yielders usually have faster DGRs and vice-versa. 

Many stocks are in the middle on both yield and DGR. Pepsi is an example of that, with a yield of 3% and 5-year DGR of 7% per year. Both values are mid-range. 

The dual goals of growth-and-income investors are to achieve both capital gains and growing dividends. They often sacrifice immediate yield in favor of fast DGR, using the latter as a clue about potential price growth. 

That is a logical premise, but remember:

  • A company’s past DGR does not always accurately predict its future DGR; and
  • The market is not always logical, so a stock’s price will not always follow the premise.
 

Dividend Safety

For the DG investor, dividend safety refers to the likelihood that the dividend may be cut.

Recall from our business model that we want companies that “reliably send growing amounts of cash to headquarters.” 

Reliable growth requires high dividend safety. A company’s dividend cannot be considered reliable if it is at high risk of being suspended, frozen, or cut.

When I first started investing, I did my own dividend safety analyses, trying to apply sound reasoning to dividend records, payout ratios, and the like.  

In more recent years, I have come to rely heavily on Dividend Safety Scores™ from Simply Safe Dividends™.

Through thorough analysis of multiple factors, Simply Safe Dividends quantifies the risk that a company may cut its dividend. It assigns each company a score from 0-100, divided into these safety categories:
Source: Simply Safe Dividends
In my own investing, I prefer stocks in the Safe and Very Safe categories, and I hold no stocks in the bottom two ranges. Here is Pepsi’s dividend safety.
I love it when information such as safety scores is augmented by statements of purpose from the company itself. My favorite company in that regard is Realty Income (O)

Realty Income, also known as The Monthly Dividend Company®, is an S&P 500 company and a member of the S&P 500 Dividend Aristocrats® index. Our goal is to deliver dependable monthly dividends that increase over time.

You cannot ask for a clearer statement of dividend intent than that.

Company Business Model

A company’s business model tells you how it makes money.

I like companies with models that I understand. Some of my favorite models are simple: subscriptions; toll-takers; suppliers of must-have goods or services; and legal monopolies (like utilities).

Not all models are that obvious. Some companies’ business models are more difficult to comprehend. 

Or they may be outside your areas of understanding. Warren Buffett famously has a “too-hard” pile. 

There’s a whole bunch of things I don’t know a thing about. I just stay away from those. I stay within what I call my circle of competence. Tom Watson [founder of IBM] said it best. He said, “I’m no genius, but I’m smart in spots, and I stay around those spots.” – Warren Buffett

To understand how a company makes money, you do not need to comprehend all the technical details about its products. But you ought to understand its industry, sensitivity (or lack thereof) to economic trends, susceptibility to obsolescence, market position, competitive advantages, and the like.

If you're prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won't get bored. – Peter Lynch

Following Lynch’s advice, a good practice is to write out a concise paragraph about the company as an investment proposition, in simple language. Explain what the company does, how it makes money, and why you think its business is sustainable. 

I follow this rule: If you cannot understand it, do not invest in it.

You can find the information you need from the company’s website as well as articles and stock reports. The best DG companies are usually outstanding businesses.

  • Dominant in their industry.
  • Proven, time-tested business models.
  • Steady growth in revenue and profits. 
  • Sustainable competitive advantages (called moats).
  • Reliable generation of excess cash above and beyond what the company needs to thrive and to grow.
 
The fact is that it requires an outstanding business to increase its dividend for many years in a row. Weak businesses simply cannot do it.
Source: Author, using Bing Chat

Financial Health

Obviously, an outstanding DG company will has solid financials, because those are the source of the dividends. Dividends cannot be faked – a company must have cash to pay them.

I look at several metrics. My approach is that the company needs to convince me that I ought to own it. My usual standard of proof is “clear and convincing evidence.” So the company does not have to be perfect on every measure, but the total picture needs to be very good.

Here is a checklist of things to look for:

  • Growing revenue
  • Positive and growing earnings per share (EPS)
  • Positive and growing free cash flow (FCF)
  • Good profitability and efficiency – return on equity (ROE) and operating margin
  • Strong balance sheet – not crippled by debt

Here are a few examples. First, revenue and EPS:
Source: Simply Safe Dividends
You can interpret these charts almost at a glance. PepsiCo has increased its revenue for 7 straight years. Its EPS has consistently been positive and growing, up 65% over the past decade.

Pepsi’s profitability and debt are good too:
Source: Simply Safe Dividends
The dashed lines are benchmarks of good performance. On the left, we see that Pepsi consistently exceeds the benchmark for ROE, and on the right, the company has been significantly better than the benchmark for ability to pay off its debt. Pepsi’s fine A- credit rating reinforces the strength of its financial position.

My bottom line on Pepsi’s finances would be that it has been a consistently growing, profitable, and efficient company. That’s the kind of company we want.

Valuation

The final area I want to highlight is valuation. Because stocks are traded in the market through a bidding process, a stock’s current price may or may not reflect its inherent value. 

Even a great business is unlikely to be a good investment if its stock is overvalued. Valuation helps you determine whether a stock is selling over, under, or at a price that matches its true worth.  

I emphasize valuation for two reasons:

  • Over the long term, I do not want to lose money on a stock. Indeed, good price returns are a secondary goal for me.
  • Stocks selling at fair prices (or sale prices) have better yields, because yields move inversely to stock prices.

I calculate valuations by averaging the results from a few standard approaches for determining fair prices. Or you can look up a few stock analyst estimates and average them out. Your brokerage probably provides many resources for figuring fair prices. My suggestion is not to overpay.

On Simply Safe Dividends™, valuation is referred to as Timeliness, because it answers the question whether now is a favorable time to purchase a stock.
Source: Simply Safe Dividends
We see that this approach offers four ways to think about timeliness:

  • Upper left: Dividend yield compared to its 5-year average. The idea is that a stock selling at a better price will have a relatively higher current yield. Pepsi’s is slightly higher.
  • Upper right: Relative PE ratios. Pepsi is selling for about 10% off its 5-year average PE ratio.
  • Lower left: PE relative to sector. Pepsi is selling for 22% more than the average of stocks in its sector (Consumer Staples).
  • Lower right: Price relative to past 52 weeks. Pepsi’s price is 14% lower than its highest price over the past year.

These mixed indicators suggest that Pepsi is selling for a fair price – or as it says at the top of the display, “[Pepsi is] reasonably valued if you believe in the company’s long-term outlook.” 

Conclusion

Pick DG stocks to match your goals, such as sizable current income, fast dividend growth, or to build over the long-term an income-generating machine for retirement. 

The common elements among all DG stocks are (1) they pay a dividend and (2) they grow it regularly. All the other differences are matters of preference and diversification.

Whatever kind of DG stocks you want, do the basic research needed to identify them. Areas to look at include:

  • Yield
  • Dividend growth rate
  • Dividend safety
  • Business model
  • Financial health
  • Valuation

If you get a decent handle on those factors, and do not give in very much on your requirements, you will be well on your way to reaching your goals.

Thanks for reading!

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