This is a guest contribution by Ben Reynolds. Ben runs Sure Dividend, which uses The 8 Rules of Dividend Investing to build high quality dividend growth portfolios for individual investors.
ALSO READ: What Are Dividends and How Do They Work?
The point of owning a business is to make money. If you owned your own business, you’d require a stream of income coming into your pocket every month.
Why do we treat owning fractional portions of businesses (investing in stocks) any differently?
Dividend investors don’t. They demand their stocks pay them, in cash. The easiest way to measure this is through dividend yield.
The dividend yield is simply the dividends paid per share divided by the stock price. A stock that pays a $3.00 dividend per year and has a $100.000 share price would have a 3% dividend yield, for example.
Some of the most well-known investors in the world silently benefit from dividends. Take Warren Buffett as an example. His 4 top holdings (which make up over 60% of his portfolio) all have dividend yields of 2.7% or higher. They are listed below:
- Kraft-Heinz (KHC) has a dividend yield of 2.7%
- Wells Fargo (WFC) has a dividend yield of 3.1%
- Coca-Cola (KO) has a dividend yield of 3.2%
- IBM (IBM) has a dividend yield of 3.5%
Ideally, you want the businesses you invest in to pay you rising dividends year-after-year. For this to happen, you need to invest in high quality businesses with strong and durable competitive advantages.
To get the most dividend ‘bang’ for your investing ‘buck’, these businesses should be trading at fair or better prices.
This article takes a look at 3 important criteria for dividend investors to consider before investing in a dividend paying stock.
Criteria 1: Dividend History
How long has the stock you are going to invest in been paying dividends?
Businesses with long histories of paying rising dividends are more likely to continue to do so. There’s a certain corporate inertia there. The business has already proven the ability to pay rising dividends over time, and the company’s management has already proven willing to do so.
When a business has a long history of rising dividends, you don’t have to guess at if dividends are a priority for the company – or if the company is able to pay dividends – you already know. But how long of a history should you look for?
I argue, the longer the better. There is a select group of S&P 500stocks with 25+ years of consecutive dividend increases. There are only 50 of these stocks, total. They are called Dividend Aristocrats.
Interestingly, the Dividend Aristocrats Index has trounced the market over the last decade. The Dividend Aristocrats Index has returned 10.7% a year over the last decade – versus 7.5% a year for the S&P 500.
The Dividend Aristocrats Index is made up of well-known established businesses. Companies like McDonald’s (MCD), Coca-Cola, and Wal-Mart (WMT); the bluest of blue-chip businesses.
In short, dividend history matters. The Dividend Aristocrats Index’s performance over the last decade is proof of that.
It’s intuitive when you think about it. Businesses that are able to reliably generate enough cash to pay more out to shareholders every year should outperform businesses that can’t – or won’t do the same (on average, over the long run).
Dividend history is important in investing, but it is not everything. The price you pay also matters a great deal.
Valuation is discussed in the next section of this article.
Criteria 2: Valuation
“Price is what you pay; value is what you get. Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
The problem with great businesses is other people also know their great (most of the time). This causes their share prices to be bid up – reducing future returns.
Think about it like this. If you could buy a magic box that paid you $1 a year forever, how much would you pay? Maybe $10. But, the lower the price, the better. Certainly, you wouldn’t want to pay $200 for this magic box – it’d take $200 years to break even.
That’s not exactly a good financial move.
When you think about buying a stock as owning part of a business, you will naturally consider the value you are getting for your purchase.
Valuation can be summed up easily; the lower the valuation, the better.
But what is ‘value’? In theory, the value of a business is the sum of its cash flows discounted back to present value using an appropriate discount rate. If this sounds impractical, that’s because it is. We don’t know the future cash flows of any business (unless you are the world’s greatest fortune teller). All we can do is guess at what they may be.
Because of the obvious inaccuracy of this, it’s more practical to gauge a business based on the amount of money it is making today. That’s what the price-to-earnings ratio is for. The price-to-earnings ratio shows how much you are paying for a dollar of a company’s earnings.
A price-to-earnings ratio of 20 means the company is trading for 20 times the amount of earnings it has generated over the last year. If the company didn’t grow (or shrink), and paid out 100% of its earnings as dividends, it would take $20 years to get you money back.
The S&P 500 is currently trading for a price-to-earnings ratio of 25. Its historical average is 15.6. Because of this, it is difficult (but not impossible) to find high quality dividend paying stocks trading at a discount.
So far, we’ve covered both dividend history and valuation. The next criteria to consider before investing is the expected total return of your investment.
Criteria 3: Expected Total Return
Returns in the stock market don’t come from magic. There are only 3 ways you can make money in the stock market:
- The business you invested in grows
- The business you invested in pays you a dividend
- The business’s valuation multiple changes
We’ve already discussed valuation multiples. If the perception surrounding a stock changes – and the price-to-earnings multiple is bid up from 10 to 20, your stock will double (if earnings-per-share remain unchanged).
Whenever you get paid a dividend, that is a return as an immediate return.
When a business grows, it may or may not be reflected immediately in the share price. Over time though, the performance of your investments will closely match underlying business growth (assuming no massive valuation changes).
Learning how to calculate expected total return for a stock is important to investing success. An example of expected return is below:
Imagine a stock has a dividend yield of 3%. You expect its price-to-earnings ratio to go up by 10% over the next 5 years – from 15 to 16.5 – growth of around 2% a year. You also expect the business to grow its earnings-per-share at 5% a year. This business would have an expected total return of 10% a year from:
- 5% from earnings-per-share growth
- 3% from dividends
- 2% from valuation multiple changes
Analyzing a potential stock investment through the lens of expected total return will show whether your expectations for an investment are realistic. If a business has grown its earnings-per-share at 5% on average for the last decade, you should have a good reason to think it will growth them at 10% a year next decade, as an example.
Putting it All Together
Narrowing the search for high quality businesses with strong competitive advantages by looking at businesses with long dividend histories is the first criteria we discussed in this article.
Making sure these businesses are trading at fair or better prices (valuation) is the second criteria.
Estimating expected total returns was the final criteria.
Taken together, you can use these 3 criteria to vet your potential investments. Together, they will help you identify high quality businesses trading at fair or better prices suitable for long-term investing to compound your wealth over time.
To learn more about dividends and how stocks are priced, check out the our course Going Deeper with Stocks!