Let’s get right into it.
Most investors absolutely suck at analyzing companies.
Why?
Well, remember this?
- Earn more revenue
- Push costs low
- Convert that difference into profits
- Capture those profits as a cash flow
Of course, you do.
Finding companies with high revenues isn’t the hard part.
A quick search in Google will even rank these for you.
The same goes for operating expenses, profits, and free cash flows.
Locating such financial data isn’t the hard part.
A trip to Yahoo Finance will do that.
Sorting out the signals from the noise in this era of information overload is the difficulty of stock analysis.
It takes practice and time to not only isolate the significant data points but to find a way to balance and prioritize contradicting information to come up with an informed decision.
I’ve seen investors analyzing stocks for years still lead to terrible investing decisions because they weren’t conscious of what they were trying to do.
When you’re stuck in the land of numbers it’s so easy to think that your next stock choice is going to be the one that finally gets you the returns that you want.
However, when you’re assuming your position as a business owner and seeing this stock that you’re analyzing as a bigger business then you can tell when something isn’t right.
Which is why we ask 30,000-feet questions about the business first before diving into the numbers here at Dividend Labs.
Specifically, we ask three questions and three questions only:
- Is the dividend safe?
- Will the dividend grow?
- How much should I pay for those dividends?
Is The Dividend Safe?
Dividend safety is our first and foremost question because we’ve got to focus on our goal of paying off our personal daily expenses.
Rent, Wifi bills, and gas money will not stop for anyone.
And so must your dividends.
They must come quarter after quarter like clockwork.
Because without such consistency, durability, and security — there will be no financial freedom.
There’s no freedom in being financially free for two months and then going back to the grind because your dividend paycheck has been cut.
This risk of a dividend cut is, mind you, an omnipresent risk.
We aim to manage the risk down to a controllable level by approaching the question of “Is the dividend safe?” from two directions.
First, we take a quantitative look at the business’s financials.
We want to see growing revenues, growing net income, and growing free cash flow.
Because growing dividends are paid from growing free cash flow and growing free cash flow comes from growth net income which in turn results from growing revenues.
If you miss one of those rings the entire chain falls apart.
Say you’ve got growing dividends paid from stagnant free cash flow.
There’s only so much that the dividend can grow before it’ll hit a ceiling when the free cash flow fails to support it.
A mid-single-digit growth rate over 10 years for these metrics would be ideal for large, established companies.
Beyond this, if the company can pull off a low-double-digit growth rate — it’s a keeper.
And we also need to see a progressive share count decline.
You’d be surprised if I told you this is one of the financial metrics that even seasoned investors miss out on.
Share insurance is also known as the silent killer in investing because it dilutes our per share ownership stakes as we’ve seen in the previous section.
This cuts into dividend safety as a company needs to pay more dividends per each year to an increasing number of shares —
An exponential burden on the company’s ability to afford it.
Second, and taking a more qualitative angle, we come to the concept of economic moats.
Visualize these moats — those wide, man-made rivers that surrounded medieval castles.
They protected the warlords within the castles against attacking enemies trying the take over the empire.
Similarly, economic moats figuratively protect businesses against their competitors who are trying to eat into their market share.
As difficult as it is to quantify these moats, their impact is real.
The wide the economic moat, the more likely a business is able to stand against encroacher competitors, and the safer its dividends are.
Well, we don’t have to talk about dividends anymore if the business paying it has been engulfed by its competitors.
Here’s the list of possible economic moats that a business can command:
- Economies of scale (Ability to produce a lot at once)
- Low-cost producer (Ability to produce cheaply, usually in conjunction with #1)
- Network effect (A bit confusing to wrap your head around, but essentially: the more users of the product, the more benefit each user is able to derive from the product, the more likely the user is going to continue using the product. Think: Ebay, Facebook, YouTube etc.)
- Barriers to entry (Products that are hard to copycat. Think: pharmateutical agents, F35 fighter jets)
- High switching costs (Products that are costly for users to switch out of. Think: insurance [cost of loosing premiums], Microscoft Excel [cost of loosing time and effort already spent on learning Excel and more time and effort to learn an alternative software])
- Brand name (Products that are famous. Think: Apple, Starbucks, Nike)
It is said that Warren Buffett picks his investments based heavily on whether the company is operating with wide AND multiple economic moats.
Examples are abundant:
- The Coca-Cola Company (KO): economies of scale, low-cost producer, brand name.
- Visa Inc. (V): economies of scale, network effect, barriers to entry, brand name.
- Apple Inc. (AAPL): network effect, barriers to entry, high switching costs, brand name.
If the stock you’re analyzing checks both boxes on the financial metrics and economic moats, you can be more than certain their dividend should be in good hands.
Will the Dividend Grow?
Dividend growth is the next question that we’ll ask after dividend safety.
Because why bother asking if growth is not even going to be around in the next 10-20 years?
There’s no way for companies to bulldust their way around this since all the data are laid in plain sight.
We look for consistency and meaningful growth here.
We want to see companies with a track record of growing their dividends consecutively for at least the past ten years.
And of course, ten years is just an arbitrary number.
There’s nothing special about it.
All it tells you is that the company has been able to grow its dividends for the past ten years.
Nothing more.
Nothing less.
It doesn’t mean the company will continue this growth next quarter.
Neither does it the company wouldn’t simply cut the dividend.
But I’ll tell you this:
When a company has built out a reputation to consistently grow its dividend and has touted the feat as business success, there’s an ever-greater resistance to do otherwise.
The dividend feels more like an obligatory expenditure to the company as the track record progresses.
Imagine you’re the CEO of 3M Corporation (MMM) and you’ve been growing your dividends for more than half a century (64 years to be specific), would you want to be hated by history as the CEO who ruin the six-decade run?
No.
This is why 3M has been loading up on debt just to sustain their dividend (not a good sign) because they’ve been raising their dividends on a background of stagnant top-line revenues (not a good sign either) and you would have noticed these bad omens since you’ve already asked the first question regarding dividend safety.
What I’m trying to say here is that dividends are sticky and a wise man once said that the next consecutive dividend raise is the best proof of future dividend growth.
Maybe it was me who said it.
I don’t remember.
So you’ll want to look into dividend champions (≥10 years of consecutive dividend growth), dividend aristocrats (≥25 years), and dividend kings (≥50 years).
Even when a company is boasting a track record of dividend growth, we need to scrutinize whether the growth rate is meaningful.
Companies may give you a raise of 0.00000001% just the continue their dividend growth streak.
3M die-hard fans are going to kill me, but them giving a 0.7% raise seems to me like they’re doing just that.
Thanks, but I’m outta here.
When I say meaningful I mean at least inflation-beating.
Because the dividend growth rate cannot even match inflation, time is going to eat away at your dividend gains and eventually your original capital.
So much for Financial Independence and Retiring Early.
That’s the reason we should aim for mid-single-digit annual growth rates for dividends.
How Much Should You Pay?
When we’ve discovered a stock paying a dividend is both safe and growing, we can then turn to the last question of the three:
What is a fair price to buy?
This question can blow up into a very complex discussion that’ll make this guide way too long.
And this is already a long-ass guide.
But if you’re the type of nerd who simply cannot sleep before completing the journey down a rabbit hole along with Wikipedia’s backlinks on a subject, shoot me an email at nic@nicfok.com and I’ll be more than excited to open this pandora’s box with you with two glasses of Chianti.
So I’m not going to dive too deep into this but the gist of coming up with a fair value for any dividend growth stock effectively is using the Discounted Cash Flow (DCF) Model and the Dividend Return (DR) Model.
The DCF Model builds on the premise that a business’s worth is the sum of all its future cash flows discounted back to today’s value.
Because a dollar today is worth more than a dollar tomorrow (cf. the time cost of money).
On the other hand, the DR Model takes a slightly different approach by focusing on the total return of any dividend growth stock, which is a combination of dividend yield, dividend growth, and share count decline.
A unique aspect of this valuation model, if you haven’t noticed, is that it bases its estimation on three of the most quintessential metrics in dividend investing specifically.
I’ve found these to be complementary models in coming up with a fair price for dividend growth stocks.
What Is My Stock Analysis Workflow?
I’ve received this question too many times so I’ll just include this section here.
Whenever I see potential in a dividend growth stock, I run it through my 4-phase workflow.
I research the answers to the above three questions thoroughly through the process.
This workflow has been protocolized into the system called the Dividend Lab Manual.
It’s basically an online Google spreadsheet template that provides a plug-and-play stock analysis system.
You can grab yourself a copy of the Dividend Lab Manual HERE.
It’s completely free.
I just need an email to send it to.
Click HERE to get your copy before we move on to discuss the details of how I go through it.
Oh, and if you’re sick of reading too much text already, you can head over to the Dividend Labs YouTube channel to see my workflow in action on real-life dividend growth stocks.
But before you head over to YouTube, make sure you go get some popcorn because it’ll be a long ride.
Phase 1: Realest Stock Screener.In the first phase, I run through the “Realest Stock Screener” to see whether the stock is even worth diving deeper into.
I scan the dividend growth streak, payout ratio, dividend yield, and 10-year dividend compound annual growth rate on MarketBeat and Seeking Alpha to assess for dividend growth.
To gauge its dividend safety I get a snapshot of its financials (revenue, net income, free cash flow, share count) through the bar charts on Macrotrends and identifying its economic moats by reading the section of “Management’s Discussion and Analysis” in the annual report.
Phase 2: No BS Reports.If the big picture looks good on this initial screen (which takes 5 minutes), then I’ll proceed to the second phase called “No BS Reports”.
I’ll be refining my answers to the first two questions on dividend safety and dividend growth by digging into the actual numbers generated by the company in its financial statements.
I want to see the hard numbers back up our impression in the Realest Stock Screener.
For dividend safety, we focus on three groups of numbers:
- Income (to support dividend): revenue, EBITA, free cash flow.
- Profitability (to quantify width of economic moats): EBITA margins, return on equity, return on invested capital.
- Debt (to assess risk of bankruptcy): net debt to EBITA ratio, interest coverage ratio.
For dividend growth, we figure out the precise dividend 10-year compound annual growth rate.
The second phase is the most tedious as it requires the transferral of individual data points from the financial statements into the spreadsheet system.
Usually takes me 30-minutes per company, and hey, practice makes perfect.
Phase 3 & 4: Discounted Cash Flow Model & Dividend Return Model.With the No BS Report indicating strong dividend safety and growth, I then tackle the third question by coming up with a fair value using the above valuation models.
Although the calculations do take time to comprehend, making use of the models for fair value calculation is rather convenient given the intuitive setup of the system in the Dividend Lab Manual.
Just fill in the orange blanks with the corresponding information and you’re fair value calculation would be on its way.
I lastly compare my calculations with those from reputable analysts at Morningstar and CFRA to add depth, balance, and weight to my final decision.
From here you can start buying the perfect dividend growth stock.
But wait, you don’t have a brokerage account yet?!
Why didn’t we start with a brokerage account first?
Because there is no point in starting something when you don’t understand the foundation.
Now that you do we can start to look at the technological side of dividend growth investing.
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