Introduction

Owning shares of stock in a company that pays a dividend is a great way to generate passive income. The dividend is a stream of income you receive usually on a quarterly basis and the dividend income would be on top of any capital gain incurred when the company stock price increases.

When a dividend is paid out, you are getting a portion of the company profits. The dividend yield is one financial ratio important to compare when looking for dividend paying stocks.

Dividend yield explained.

The dividend yield is the percentage of the share price the company pays out dividends each year.

In December 2021, the dividend yield of the S&P 500 was 1.27%.

If you owned 1 share of the S&P 500 fund, you would receive $1.27 in dividends annually.

Stocks paying a dividend usually reward investors over the long term (5 – 10 years) as long as the company and industry are stable.

Dividend Investing Strategies

There a 3 common dividend investing strategies: 1) High Dividend growth rate, 2) High Dividend Yield, 3) Dividend Reinvestment Plans (DRIPS)

High Dividend Growth Rate

The high dividend growth rate strategy focuses on buying stock in companies that pay dividends but are growing the payout rapidly. With this strategy you are buying shares in a profitable company initially with a dividend payout that maybe low, however, as the company rapidly increases the dividend payout over a five- or 10-year period, you will make a large amount of income.

High Dividend Yield

The high dividend yield approach focuses on companies that are slowly growing and have a high cash flow. This usually allows the companies to fund large dividend payments that provide you with immediate income.

Dividend Reinvestment Plans (DRIPS)

Many brokers and companies paying dividends offer Dividend Reinvestment plans (DRIP). This allows you to reinvest your dividends to purchase more shares of stock instead of taking the dividend as cash.

The DRIP strategy focuses on companies that offer Dividend Reinvestment plans. Then analyzing and identifying high quality companies with safe dividends and starting the dividend reinvestment plan. Many folks use this strategy to invest for the long term. Once the dividend reinvestment plan is setup every dividend paid will reinvest in more shares of the company and will compound the income stream over time.

Before investing in dividend paying companies, you will need to understand the health of their business and verify the dividend payout is safe. It is important to do your own research before investing in the stock of a company.

Dividend Investing Financial Ratios

Several financial ratios are helpful in evaluating the performance of the underlying business. Financial ratios are calculations and/or metrics used to research and compare investment opportunities.

Many financial ratios are included in financial statements, annual reports, and investor presentations. Others you will need to calculate yourself. Examples of financial ratios include: Quick ratio, Current ratio, price to earnings, debt coverage, return on assets.

We now will review financial ratios that are helpful when evaluating dividend paying companies.

Dividend Payout Ratio

The dividend payout ratio measures the percent of a companies’ earnings paid out for the dividend. Companies with lower payout ratios are assumed safer. A divided from a company with a high payout ratio (above 75%) is assumed riskier since a majority of the company’s earnings are used to payout the dividend.

The dividend payout ratio formula is calculated as: Amount of Dividends paid / Earnings generated for time period.

If a company paid $3 in dividends in a year and earned $10 that year, the dividend payout ratio is: $3/$10 = 30%.

Dividend payout ratios of less than 60% are generally considered safe. A higher payout ratio could be considered if a business is extremely stable and the company maintains strong financial health. For example, a higher payout ratio maybe considered safe for a regulated utility business.

Reviewing the trend of the dividend payout ratio over time (3 – 5 years) is important to determine if the payout ratio is consistent or not. Companies with greater consistency in the payout ratio are generally safer.

Free Cash Flow

It is important to understand the free cash flow of the business. Free cash flow is the fuel for dividends and stock repurchases.

The calculation for free cash flow is:

Cash Flow from Operations = Net Income + Non-Cash Items + Changes in Working Capital

Minus

Company Capital Expenditures (money spent on property, plant, and equipment)

Companies that generate free cash flow consistently in virtually every economic environment are much safer. And dividends from companies with consistent and growing free cash flow are considered safer and more reliable.

Operating Profit Margin

Generally speaking operating profits represent the company’s earnings before interest and taxes. This allows the analysis to focus on comparing the profitability of actual operations. A company with a high and stable operating profit margin is very desirable.

The formula for Operating Profit Margin is: Operating Profits / Total Sales

It is important to understand the level and consistency of the company’s operating profit margin. Company’s with high and stable operating profit margins are more desirable as they help earnings compound quicker.

Sales Growth

Trends in sales growth tell us about the stability or volatility of a company’s business model and the ability of it to continue to expand.

Companies with stable sales growth in different economic conditions are more desirable and their dividend safer.

Sales growth is calculated by subtracting one revenue period from another revenue period and expressing the difference as a percentage of the former period.

Example of Sales growth calculation. Company X sales in 2019 were $200. Company X sales in 2020 were $250.

Sales growth for company X in 2020 is calculated as ($250 – 200) / $200 = 25%.

It is important to look at both the level and consistency of sales growth over several years to determine the strength of the business model of the company.

Return on Invested Capital

Companies earning higher returns on invested capital are compounding capital faster and are considered more desirable companies to invest in.

Return on invested capital (ROIC) assesses a company's efficiency at allocating the capital under its control to profitable investments. Comparing ROIC to a company’s weighted average cost of capital (WACC) reveals whether invested capital is being used effectively.

Return on invested capital measures a company’s return on equity and debt. Measuring a company’s return on both equity and debt, allows for a better comparison of companies with different capital structures.

The formula for Return on Invested Capital is: ROIC = NOPAT / Invested Capital

NOPAT = Net Operating Profit After Tax

Or another formula is Return on Invested Capital = (Net Income – Dividends) / (Debt + Equity)

It is important to look at both the level and consistency of Return on Invested capital over several years.

Companies with a stable, double digit return on invested capital over several years are more desirable to invest in and their dividends are considered safer.

Asset Turnover

Asset Turnover measures how many dollars of sales each dollar of assets generated. This tells us how efficiently is at generating sales from its assets.

The formula for Asset Turnover is: Total Sales / Total Assets

More profits can be generated by companies that generate great sales from their asset base. Companies with low operating margins can generate a solid return on invested capital for shareholders when the asset turnover ratio is high.

Companies with a high asset turnover ratio are more desirable and generally speaking their dividends are safer. Companies with high asset turnover ratios generally have higher return on invested capital.

Price to Earnings Ratio

One of the most popular valuation ratios investors use is the Price to Earnings ratio. The formula for calculating is very simple.

Price to Earnings ratio formula: Company Stock price / Earnings per share over 1 year period

Generally speaking companies that trade at Price to Earnings ratios of less than 20 are more reasonably priced.

Total Shareholder Return

While tempting to focus on only the dividend yield of a dividend paying stock, it is important to look at the total return on the investment.

Total Shareholder return measures both the stock price increase and any dividends paid. The total shareholder return is the measure investors should look at.

Total Shareholder Return formula: (Stock price increase + Dividend paid per share) / (Per share purchase price)

For example: You purchase Company Y at $100 a share. Company Y paid a $5 per share dividend in the year. At the end of the year company Y stock traded at $110 a share. The Total Share holder return is calculated as follows: Stock price increase = $110 - $100 = $10. $10 + $5 dividend per share = $15.

$15 / $100 = 15%. So the total shareholder return is 15%

Companies with a Total Shareholder return that outperforms the S&P 500 or DJIA are more desirable than companies where the Total Shareholder return is below the returns of the S&P 500 and/or DJIA.

Financial Ratio Summary

For dividend investing it is essential to analyze different companies using the financial ratios to identify high quality companies that pay safe, growing dividends.

These financial ratios help determine the underlying quality of the business and the safety of the company’s dividend.

Other important aspects to examine are debt levels, recession performance of the company, near-term business trends, industry factors and trends, and comparison of the company to other companies in the industry.

Final Thoughts on Dividend Investing

Understanding and using financial ratios to assess dividend paying investments is important. Identifying high quality businesses where the dividend payout is safe and growing will provide a margin of safety for your investment.

Dividend investing is a worthwhile long term investing strategy especially if you reinvest the dividends. The compounding effect of the dividend reinvestment will generate a decent stream of cash flow after several years.

To be a successful dividend investor it is important to take the time to assess different investment opportunities using at least the above financial ratios. There are many other financial ratios to consider so determine any others that are important and get as complete of a profile of the business before investing. This will help to ensure that you sidestep all the avoidable mistakes when investing.

To learn more about stock investing check out the "Beginner's Guide to Stock (Equity) Investing" post.

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Sunday, March 13, 2022

Dividend Investing Strategy

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