Analysing and researching a potential stock for dividend investing is essential to managing our risk. We must carry out our due diligence to protect our capital as much as possible and better still, maximise our returns.
All of you will do this to one extent or another, but we’re always looking to improve as investors, learn new skills and ways to manage our portfolio, and here I’ll go through some of the key concepts to look at when analysing a potential dividend stock.
The metrics I’ll be discussing relate to the underlying stock itself but mostly around the dividends, so if you’re looking at investing in stocks that pay out dividends to shareholders to earn a growing and sustainable passive income over time then this article is for you.
Reliability
The first thing to assess when looking at a stock that pays a dividend is how reliable that dividend is. It’s all well and good if a stock price has fallen to a point where it advertises a dividend yield of 10%, but how sustainable is that? How long can the company keep paying such a high dividend before it has to cut or even suspend the dividend entirely?
There’s no point investing in a company for passive income if that income is not frequent and consistent. Although dividends are never guaranteed, we can study the track record of companies to give us an indication of whether future dividends will be paid out.
To find this out I use Dividendmax.com. Their website is intuitive and simple to use. Here I can type in the name of the company I’m looking to invest in, or the ticker symbol to obtain an all-encompassing view of their dividends and a track record.
Johnson & Johnson Annual Dividends
In this example I’ve searched for Johnson & Johnson, where I can see a current dividend yield of 2.7%. Not particularly high but outpaces the S&P average yield. What is more impressive is the consistent track record JNJ has shown of both paying and growing the dividend over the lifetime of the company. Below I can also see the dividend growth in a percent figure to give me an idea of how much my passive income stream will grow over time.
This is not a sponsored post, I just think that this website is very useful so be sure to give it a try when looking at your next potential stock. For a more comprehensive site that provides high quality charting and metrics, I would also recommend Morningstar.
Payout Ratio
On the subject of reliability, another metric to look out for is the payout ratio. This is a metric used to show the dividend paid compared to the companies profits and can inform you as the investor if the company is suitably able to service the current dividend with the profit it’s making. This is calculated by taking the annual dividends per share and dividing it by the earnings per share.
A high pay-out ratio indicates that the dividend paid is near the level of net income and could call into question dividend sustainability. What’s more important is how the pay-out ratio is trending. A steadily rising pay-out ratio can indicate a maturing company where share prices are unlikely to appreciate rapidly.
However, a spiking pay-out ratio could mean the dividend is heading into unsustainable territory. If a company’s pay-out ratio exceeds 100%, it is returning more money to shareholders than it is earning and will probably be forced to lower the dividend or stop paying it altogether. This is not a guarantee, as was the case with many companies during the stock market crash of 2020.
Take this example comparing Unilever and Microsoft. Both are dividend paying companies that consistently grow their dividend. Unilever pays a great dividend of 3.7%, while Microsoft has a more conservative yield of 1%, focusing more on growth and share capital appreciation.
At first glance you might think Unilever is the best bet, but the current dividend sits at a pay-out ratio of 82%, higher than its 5-year average of 65%. On the other hand, Microsoft’s pay-out ratio is only 28%.
If Unilever’s margins become squeezed as inflationary pressures persist then Unilever may be faced with the difficult decision of either taking on debt to continue their track record or cut it entirely. Companies with such a long streak of growing their dividend are extremely reluctant to cut them since it can drive the share price down and reflect poorly on management’s abilities.
Microsoft on the other hand has ample room to continue to grow its dividend and service it through net income. Its 3-year dividend growth is a staggering 31.45%, meaning investors won’t be left with a low dividend yield for very long.
Dividend Cover
If you flip the pay-out ratio around you are also able to calculate the dividend cover, effectively showing how many times the income of the company can cover the dividend payment.
A high dividend cover (or a low pay-out ratio) indicates more room for potential dividend growth, so logically we want to look for companies that can maximise their net income as much as possible to provide room for substantial dividend growth that we as passive income investors can benefit from.
Take Segro as an example of this. The company pays a modest dividend of 3% while having an extraordinary dividend cover of 13.95. Not only does the company have room to grow the dividend as it is, but the fundamentals for industrial real estate owners provide further growth in the future.
With a shortage of warehousing in the UK and ever-increasing demand by occupiers, rental growth and further progress in development pipelines will allow Segro to grow its top and bottom line, providing a strong backdrop for shareholders to receive a sustainable and growing dividend.
The pandemic led to a surge in online e-commerce and the need for distribution warehouses and fulfilment centres, and Segro as an owner and operator of these properties was the beneficiary.
While rising rates are detrimental to property valuation and may continue to be a headwind in the short term, Segro is a ‘best in class’ owner / operator of warehousing and logistics properties.
Comparative Yield Analysis
Another point to look out for is how does the yield compare relative to historic 12-month trailing yields? This compares what the stock costs relative to other times in history and can give signal a few things to us.
Firstly, it can tell us if the stock is richly valued compared to the past. With the stock markets trading at inflated levels in t he past 2 years, you won’t be surprised to find this the case for many dividend stocks.
Take a look at the dividend yield over time for Walmart, a company with a 45-year track record for consecutive dividend increases. With a current yield of 1.7%, the stock doesn’t pay as healthy a dividend as it has in the past, suggesting investors have to pay a higher premium for a stable yield.
On the other hand, if the dividend yield is drastically higher than the past, it may indicate a potential cut or suspension. Shell was the perfect example of this back in 2020.
In the wake of the pandemic and the crash in demand for oil the company was forced to slash its dividend by 66%, the first time since World War 2. A higher yield relative to the past can signal opportunity, or it could be a sign to steer clear.
Relative Valuation To Peers
Another factor to consider when researching a potential investment is relative valuation compared to industry peers. A company might offer an attractive dividend and solid growth prospects, but what good is that if there are 4 other alternatives in the same industry?
Comparing your stock to its competitors can tell you if its fairly valued. If it’s significantly cheaper, why is that? Does the market not feel that the company can deliver on growth targets, or is it simply undervalued?
If it trades at a premium to its competitors, does it have a unique offering that sets it apart? Are its future cash flows guaranteed by a wide economic moat? Or is it simply a ‘flavour of the month’ stock that is due to re-rate lower? Let’s look at a few examples by comparing the UK supermarkets.
Recently, Morrisons was auctioned in a bidding war between two US private equity companies. The FTSE250 listed supermarket was successfully won at auction by Clayton, Dubilier & Rice (CD&R) for 287p per share, beating rival bidder Fortress who offered 286p per share.
What is most interesting about the closing price is that it represents a staggering 61% premium to the share price back in June when the initial bid was brought forward. The final bid raised Morrison’s Price-to-Earnings ratio to 47.97 which poses the question, “Are UK supermarket stocks undervalued?”
The answer to the question could very well be yes. After the bidding war began, shares in both Sainsbury and Tesco gained in sympathy, up 16.5% and 19.6% respectively, however they both remain markedly cheaper than the premium paid by CD&R. Both stocks then gave up their gains as the wider markets turned sour.
Tesco trades at a P/E multiple of 10.6 with Sainsbury at 7.9, implying both could be inefficiently priced if Morrisons was considered a fair reflection of the true value of UK supermarkets.
It was said that the real estate owned by Morrisons was at the heart of the bidding war. Tesco and Sainsbury are both sizeable property investors in their own rights. Sainsbury is said to be working with a boutique investment bank to help defend itself from a potential takeover in the wake of the Morrisons acquisition.
With a current market cap of £4.75Bn, it is inferior to the £7Bn bid that it took for Morrisons to be auctioned. With a market cap of over £17.25Bn, Tesco should not face the same concerns, and with a lower P/E multiple relative to its peers and dividend yield of 4.71%, the stock appears quite attractive at its current levels.
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