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Many investors think that the most important measure for valuing a security that pays dividends is its return. I thought so when I started investing several years ago. At the time, I would not even think of investing unless a stock offered a much higher return than the market in general.
However, I have since learned that investing in dividends is not limited to a simple return. In fact, I now believe that a high return should be considered as a warning sign instead of a buy signal. That's why I focus on other factors when I judge a dividend stock.
What measures should investors use to assess income stocks? Here are three favorites.
Source of the image: Getty Images.
1. Predictable income growth
I firmly believe that the best companies are able to grow their business in all market conditions. This is not something that any business can do. Many companies are seeing the demand for their products dry up when the economy is at a standstill. However, if you can find a company that increases its revenue every year, then I would say that you have found a very solid company.
That's why one of the first things I look at when I evaluate a potential dividend stock is a graph showing its long-term revenue growth. Ideally, I would like to see the line on the graph always head up.
A shining example of a business with predictable revenue growth is McCormick (NYSE: MKC). The grocer occupies a dominant position in its market and sells its products to both consumers and businesses. This allows it to show steady income growth, as consumers choose to eat out or cook at home.
On the other hand, consider what happened to General Mills (NYSE: GIS) now. One would think that this business would also produce steady income growth, since it sells food. However, General Mills has been struggling with revenue growth in recent years, with consumers turning more and more to organic products. This change put a lot of pressure on General Mills' revenue growth in recent years.
MKC Revenue Data by YCharts. TTM = after 12 months.
That does not mean that General Mills can not change things. But since this company's business growth is clearly at a standstill, I think it makes sense for income investors to look elsewhere.
2. A sustainable distribution ratio
Once I've determined that a company's revenues are going in the right direction, I then focus on the payout ratio. This number tells us how much of a company's income is used to pay the dividend. To calculate this figure, you simply divide the payment of the annual dividend by the earnings. For example, if a company's earnings are $ 5 per share and its annual dividend is $ 2.50 per share, its payout ratio is 50% ($ 2.50). / $ 5).
Rapid mathematics shows us that McCormick's distribution rate is 33%. This means that the company pays about $ 0.33 for every dollar of net income that it earns. This ratio tells me that the company can easily afford to pay its dividend right now, and that there is plenty of room for growth even if profits do not progress. This is a good sign for investors in dividends.
On the other hand, consider Nielsen Holdings (NYSE: NLSN). The company sells media and marketing data to companies who want to know where consumers spend their time. Although it is a very profitable business that is showing steady revenue growth, Nielsen currently has a payout ratio of 113%. This means that the company pays more dividends than net income, which is obviously a situation that can not last forever.
I do not foresee catastrophe for Nielsen Holdings investors in the long run. In fact, there is good reason to think that cost reduction will contribute to the rapid growth of the company's profits. But I have to admit that Nielsen's high distribution rate gives me a break. That's why I would not consider this company as one of the best payers of dividends.
3. Strong potential for growth in net income
Large companies that pay dividends can not only pay their current dividend, but also increase their payment in the future. The only way for a company to do this in the long run is to grow its net income. For this reason, I like to eliminate low growth (or negative growth) companies from conflict even if they pass my first two tests.
For example, consider Consolidated Edison (NYSE: ED). This utility services New York City and surrounding area, which is a thriving market. The sale of electricity is a recession proof business, so the front line of the business is extremely predictable. In addition, the company's dividend consumes only 55% of profits. These figures suggest that Consolidated Edison could be a terrific dividend stock. However, the company's profits are expected to increase only by just over 3% per year over the next five years. I have trouble getting excited about this number.
But that's yet another area in which McCormick shines. Largely as a result of acquisitions and international growth, market watchers expect McCormick to increase its annual results by more than 10% over the next five years. It's fast enough for a company that's over 100 years old.
A stock of long-term dividends
Perhaps you will not be surprised to know that McCormick is an excellent title for dividend investors. With predictable revenue growth, a sustainable payout ratio and strong earnings growth potential, McCormick is checking all the boxes I'm looking for in a high-income investment. With stocks currently trading for less than 20 times next year 's earnings estimates and offering a dividend yield of 2%, I think this is an excellent stock for investors.
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