As Mark Lowe wrapped up chapter one of “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” he made a strong case for due diligence, even though dividend stocks are safer than many other types of stocks.
In chapter two, he provided nine key metrics and concepts that would guide an investor’s due diligence, thus providing part of a road map for analyzing these stocks. We will look at the first four of them in this article.
Debt-equity ratio
This ratio will help investors figure out how much leverage is being used by a company; given the idea of “leverage,” this is also known as the “gearing ratio.” It is calculated using this formula:
However, it is just a starting point; as Lowe observed, “Remember, the ratio can be affected by retained earnings or losses, intangible assets and pension plan changes. So, a more comprehensive due diligence is needed so you can completely understand the actual leverage of the company.” He added that an evaluation might be improved by bringing in short-term leverage ratios, profit performance and growth expectations.
Higher debt-equity means a company has borrowed a relatively large amount of money to operate or expand and is, therefore, riskier than a company with a lower ratio. At the same time, there is a trade-off here: Higher debt levels make it possible to generate higher output and greater profits. Basically, if the growth is greater than the interest rate, it’s a positive use of debt and vice-versa.
Be cognizant of the industry when doing this analysis: different industries have different capital structures and needs. Lowe reported that tech companies may have a debt-equity ratio below 0.5, while a capital-intensive industry like manufacturing or utilities would commonly have a debt-equity ratio of more than 2.
Dividend coverage ratio
Investors use the dividend coverage ratio to try to estimate the risk associated with receiving dividends. Lowe wrote, “DCR is a key metric in stock dividend investing, which will allow you to measure the number of times that a certain company is releasing dividends to its stockholders.”
Note that this ratio uses net income and not cash flow in its calculations. That distinction is an important one. According to Lowe, a company may report high net income, but not have enough cash to make its dividend payments. In addition, net income changes every year, making the dividend coverage ratio an unreliable gauge of future dividend payouts. Despite its shortcomings, the dividend coverage ratio is still used, but not on its own.
Dividend growth rate
Companies that issue dividends generally like to increase them each year, for several reasons, just as investors like to receive them (and might sell their shares if they do not).
In Lowe’s description, the dividend growth rate is the percentage rate of annual growth posted by a specific stock over a specific period. It is available on the GuruFocus summary page for most stocks; this screenshot shows the details for Coca-Cola (KO, Financial) at the close on Friday, Sept. 20:
The dividend growth rate is also an integral part of the dividend discount model, a tool for valuing stocks by computing the present value of future dividends. In other words, it is a way of quantitatively calculating the intrinsic value of a stock.
To calculate the growth rate, using the dividend discount model, use the formula “P = D1 / (r-g)”, where “D1” is the dividend value for next year, “r” is the capital cost of equity and “g” is the dividend growth rate.
Alternatively, an investor can use the “linear method,” which involves the use of historical data. Lowe prepared this example with the following dividend payments per year:
- 2015: $1.00
- 2016: $1.05
- 2017: $1.07
- 2018: $1.11
- 2019: $1.15
Feed that data into the formula:Â Year X Dividend / (Year X -1 Dividend) – A. That allows us to calculate the growth rates within those five years:
- 2015: Not applicable.
- 2016: $1.05 / $1.00 -1 = 5%
- 2017: $1.07 / $1.05 -1 = 1.9%
- 2018: $1.11 / $1.07 -1 = 3.74%
- 2019: $1.15 / $1.11 – 1 = 3.6%
Averaging those figures, we arrive at an annual growth rate of 3.56%.
Dividend payout ratio
This refers to the percentage of profit that is transferred to shareholders by way of dividends. It can be calculated in two ways:
- (Dividends per share / Earnings per share) x 100
- (Total paid dividends / Net income) x 100
As the formulas suggest, this explicitly shows the proportion of earnings going to shareholders and, implicitly, the proportion being kept by the company as retained earnings.
For investors, the question becomes: How much can a company pay and still have enough to maintain and grow future profits? Or, how many feathers can you pick from golden goose before you kill it?
We’re often cautioned to be wary of companies with very high dividend payout ratios. But Lowe warned that we need to do more research before deciding what’s too much: “There’s no single metric that can figure out if a payout ratio is good.” He lists these examples:
- Utilities, pipelines, telecom and other defensive sector companies enjoy stable and predictable revenues, so they can make higher dividend payouts.
- Energy and other companies in cyclical sectors have unstable revenue and more trouble predicting future revenues, so they need to stick with lower payouts.
He also pointed out companies that prioritize growth will have lower payout ratios than mature companies; higher retention of earnings provides more capital to invest in future revenue.
Do be concerned about companies with a payout ratio of more than 100%; this means the company is paying out more than it makes. It also suggests the company may be in financial difficulty.
Conclusion
Due diligence is a critical part of buying dividend stocks. While these stocks are generally safer (bigger and more mature companies) than the broad market, investors do need to know their fundamentals.
In this article, we have examined four key ratios: the debt-equity ratio, the dividend coverage ratio, the dividend growth rate and the dividend payout ratio.
Assessing and understanding these ratios will help investors make better decisions when shopping for dividend stocks.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Dividend Investing: Managing Risks
- Dividend Investing: Earning Passive Income
- Strategic Value Investing: Value Investing in Mutual Funds
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