Once you have your shortlist of potential dividend stocks, with the help of information in the previous chapters in “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” it’s time for due diligence on the relatively few remaining stocks.
Author Mark Lowe began chapter seven by stressing the importance of economic and financial issues that might affect dividend stocks. For Americans, that starts with an overview of the current U.S. economy. There are several resources he recommended:
- Federal Reserve Board.
- Research produced by banks.
- Business media, including newspapers, websites and magazines.
With that research done, it’s time for company due diligence, because the health of the company in which you’re investing is critical to dividend returns. Lowe wrote, “Due Diligence is the process of investigating a company by verifying all available public information. This involves reviewing all financials aside from other relevant materials that can help you decide if the company is worthy of investment.” This is his step-by-step process for due diligence:
1. Verify the corporation’s capitalization
The level of market capitalization will help set a broad perspective, in the sense that large-caps tend to be more stable than small-caps. Since the biggest companies have a diversified pool of investors, there is less volatility. Small-caps will show more volatility because their earnings tend to be less stable.
2. Profit margins
How much of a company’s revenue turns into profit? That’s what profit margins tell us, and from a prospective buyer’s standpoint, there is a range of acceptable margins. By digging into the details, you can also find out whether the margins are growing, contracting or staying fairly level.
At the same time, check on the company’s return on equity and its gross revenue. Again, you want to know which way the company is trending. According to Lowe, “Most dividend investors prefer companies with ROE of 50 or higher. This important detail will be key for the next steps in due diligence.”
3, What is the competition?
Now it’s time to look at the industry and to see how the company you’re benchmarking has performed in comparison with other companies in its industry. In particular, pay attention to the biggest competitor in each industry and ask:
- Is your candidate company a major player in this industry?
- How is the industry, in general, performing?
- Could the candidate’s fortunes change significantly in the next five to 10 years?
4. Valuation multiples
There are three key valuation metrics, according to Lowe:
- P/E, or the price-earnings ratio (also known as price multiple or earnings multiple).
- PEGs, or the price/earnings-to-growth ratio; as the name suggests this is an enhanced version of the price-earnings ratio, one that also factors in the growth of earnings.
- P/S, or the price-sales ratio.
Consider not only the ratios for the company you’re assessing but also its peers. Check out any significant discrepancies.
Generally, these ratios should not be taken on their own; they should be used with other metrics, and they should not be compared across different industries.
5. Who’s managing the company?
Are the founders still involved in managing the business? The younger the company, the more likely it is that the founders are still involved.
For dividend investors, the best bet is to look for companies with seasoned executives, which is quite common for businesses that have matured enough to pay dividends.
Also important: How much stock do the senior managers (insiders) hold? For information, turn to a source like GuruFocus. It provides a page of information about institutional and insider ownership for each stock it covers; this graph shows Home Depot (HD, Financial) insiders holding an increasing number of shares (the green line shows insider ownership while the blue line shows the number of shares outstanding):
6. Review the balance sheet
Use what Lowe called a “mid-level” analysis; in other words, don’t skip over the balance sheet but at the same time, don’t get bogged down in it. He recommended focusing on these points:
- What is the company’s capacity to handle short-term liabilities?
- If there is a high level of debt, is it consistent with the company’s business model?
- Check the ratings of the company’s short-term bonds.
- Does the company generate enough cash to meet its debt obligations and still maintain its dividend payments?
- What is the company’s debt-equity ratio, and how does it compare with the ratios of its peers?
- Have there been significant changes in the top-line numbers, its total assets, total liabilities or shareholder equity? If yes, why?
If any of these reviews produces a red flag, check the footnotes for explanations.
7. Follow the company’s stock-price history
A quick review of the company’s stock-price history, via its stock chart, can provide insight to investors. Lowe noted:news bender
“Trace the pattern of the stock price performance. Has it been choppy, volatile, smooth or steady?
“Be sure to also check the stock price in different periods - six months, one year, three years, five years, and 10 years. Is the general trend rising or falling?”
If there are major variations from the overall trend, what happened? Was there a change in revenue, expenses or something else that prompted the market to react the way it did?
8. Check stock options and the possibilities of dilution
Next, review Securities and Exchange Commission filings for outstanding stock options and determine when they will be converted into shares.
As Lowe pointed out, the options may be converted at different price points. This means you can estimate conversions by price levels, and once those levels are hit, the options turn into stocks and consequently dilute the value of current shares.
9. Gather expert opinions
While you will become well informed about a company if you have gone through the due diligence process, there is the potential that you’ve missed something, or even that you developed tunnel vision.
The remedy is to look beyond yourself: “Step 9 may require a bit of an extra effort on your side because you have to make sense of the general sentiment of stock market analysts when it comes to the profit growth, revenue, and other projections for at least two years from now.”
10. Examine risks, both short and long term
Lowe dealt briefly with the risk assessment process within the wider confines of due diligence. Among the points he made:
- Understand the risks involved with the sector and industry, as well as those of the company.
- Ask what, if any, disruptions are possibly coming?
- Develop worst-case scenarios that could affect your investment.
- Ask if a competitor introduces a better product, can your company survive?
Conclusion
In chapter seven of “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” Mark Lowe provided a 10-step due-diligence process.
While the specifics he provided are a good guide, in a broader sense, having a process of some kind is essential for any dividend strategy to work.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.Â
Read more here:Â
Dividend Investing: Choosing Dividend Stocks, Part 2
Dividend Investing: Choosing Dividend Stocks, Part 1
Dividend Investing: The High Dividend Yield Strategy
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