Following up on my recent “build an investment strategy” article series (you can read part #1 and part #2 here), I’m delving into the core topic: which metrics to use to select your dividend stocks.
I have already shared metrics I look at and how I use them in a stock filter (read about my dividend growth model here). But we all know there is a lot more than a few ratios to choose a stock. One company can show awesome profit growth, but hide other problems in sales or debt for example. How do you weight each metric to find the right stock? It’s important to combine them and to find the “ultimate combination”. Even better than that, if you can combine all the important metrics, give them different weights and create a scoring method; what happens? You can generate a “buy list” where stocks are attractively valued at the moment you pull the list. This is our goal with the Rock Solid Ranking.
The Rock Solid Ranking Provides a Buy List and a Sell List
With the help of our ranking, we can rapidly identify stocks that show all the great fundamentals we are looking for. Those which score at the top of the line earns the “buy mention” while those who sit at the bottom of the ranking fall into the “sell mention”.
If a company can’t keep up with a high ranking, it means its losing pace with one or more important metrics in our model. The more it loses ranking, the more it is closer to joining the sell list. On the other hand, a company improving its scores quarter after quarter definitely earns the buy mention as it shows it’s going towards the right direction. The Rock Solid Ranking goal is to provide an instant valuation of a stock according to our dividend growth investing model.
I’m not going to disclose our calculation methods here but I’ll tell you which metrics we follow. This can help you build your own investing model. Total score of a company could technically reach 100% if it was perfect on all attributes. The score can also be negative as we give penalties for negative growth numbers.
In my opinion, if you don’t sell, you can’t make money. If you can’t make money, you can’t pay dividends. If you can’t increase your sales, you can’t increase your profits and you can’t increase your dividend. This is why revenue growth is so important. The best way to measure if a company is making more money is by look at its revenue growth.
A company can run through a tough year or show hectic revenue movements. This is why we take a look at both 1 yr and 5 yr revenue growth. The first metrics to be used in our model is:
1 year Revenue Growth
5 year Revenue Growth
More weight is given to the 5 yr and penalties (negative score) are attributed to companies that show negative revenue growth. You can’t hope to increase your dividend consistently if your revenues decrease.
Showing strong revenues is important, but it doesn’t guarantee you will get strong dividend payouts. Profits drive amounts to be paid through dividends. If you look at a company like Amazon (AMZN); revenues are huge but profit is thin. Therefore, they can’t hope to pay a dividend at this point in time (especially when your P/E is 574!).
In order to make sure we don’t give a high score to a company that recently restructured its costs or sold an important asset to boost its profits, we also consider 1yr and 5yr Earnings Per Share (EPS) growth.
1 year Earnings per Share (Diluted) Growth
5 year Earnings per Share (Diluted) Growth
Earnings and revenue growth combined together weigh a lot in our model. Both metrics combined together is the key for a sustainable business model. This is why so much weight (40%) is attributed to these 4 metrics.
#3 DIVIDEND METRICS
Once we have found companies with sales and profits, it’s time to take a look at what we are looking for the most: dividend growth potential! In order to find out if a stock is not only a good stock but a good dividend stock, we use 3+1 different metrics. The “+1” is because we look at both 1yr and 5yr dividend growth percentages:
1 year Dividend Growth
5 year Dividend Growth
Dividend Payout Ratio
The 1 year dividend growth shows the company’s willingness (or capacity) to increase its dividend over a short period of time. The 5 year dividend growth confirms this willingness/capacity to keep increasing payments to shareholders.
Then, the dividend payout ratio is also very important to us. We penalize companies paying over 120% of their earnings. We didn’t select 100% as we must always take into consideration that the payout is in $ and the profit is an accounting term (including amortization for example). This is why it’s important to give some room for high dividend payout ratio companies. We also give a smaller weight to companies with very low payout ratio (0-20%). This shows the company would rather keep its money in its bank account instead of sharing the wealth with stockholders.
Finally, the dividend yield is also a debated topic. Some investors are looking at 5%+ dividend yield (I keep receiving tons of emails telling me I look for small dividend yield stocks). Some others (like me!) prefer sound businesses with dividend stocks around 3%. In the past four years, I’ve noticed that stocks paying over 4% are often showing shakier metrics than stocks with a lower yield. Dividend metrics combined together represent 40% of our ranking calculation.
#4 DEBT LEVEL
Another important data is the debt level of a company. The idea behind the choice of this fundamental is simple; debt payment requires cash flow, cash flow that could be used to pay dividends. You don’t want a company strangled by their debts and forced to make unfortunate decisions. This is why we use a debt ratio in our model:
Debt to Equity ratio
Here again, a high debt to equity ratio is penalized by negative points.
#5 STOCK VALUATION
Finally, the price you pay for a stock is also important. I’m the first one to pay a relatively high price for a great company. Still, if I can find a company that is relatively similar but traded at a cheaper price than another, I will definitely take a look at it.
We have used the following metrics in our system to give points to each stock:
P/E ratio PEG
Price to Book Value
THIS GIVES THE ROCK SOLID RANKING
We have built our scoring model to be able to select the best dividend stocks according to our investment beliefs. It is probably not perfect and it is surely not strong enough by itself to buy a stock solely based on the ranking (read here that the scoring is NOT a buy or sell recommendation). However, it gives you a strong indication of stocks you should have in or get rid of from your portfolio.
The full ranking is published and updated weekly on our other site; Dividend Stocks Rock. By becoming a member, you get access to
10 US & Canadian portfolios, (including growth and conservative models)
8 Dividend stock lists, (including high yield, aristocrats, premium and dividend growth lists)
Bi-weekly Premium Investing Newsletter
And the complete Rock Solid Rankings
What do You Think?
We were able to give value to each metric and compile them to a scoring board. What do you think of such scoring method to buy or sell your stocks? Is this something you could use to build your investment strategy? Is there any other metrics you think should be part of our model?
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