10 Factors to Evaluate Dividend Growth Stocks 

Summary:

• Dividend growth investing has outperformed the market and offers investors the potential for both income and capital appreciation.
• Identifying dividend growth stocks involves a holistic approach, as opposed to focusing on one factor like the dividend yield.
• This article outlines 10 factors to consider in aggregate to evaluate dividend growth stocks.

Dividend growth stocks have long been a popular choice for investors seeking both income and capital appreciation. And with good reason – dividend growth stocks have outperformed both dividend payers as a whole and the broader market over the past 5 decades. By consistently increasing their dividends, a key characteristic of the strategy, these companies demonstrate financial strength and stability, which are attractive to long term investors. In this article, we will examine the 10 key factors to consider when choosing dividend growth stocks. 

What is a Dividend Growth Stock?

Dividend growth stocks are companies that have a history of consistently increasing the dividend paid to shareholders. These stocks are often more established and well-managed companies with strong fundamentals that generally have profitable operations. One of the key characteristics this strategy offers is that dividend growers provide a reliable, steadily increasing source of income. These characteristics can potentially offer a degree of downside protection which can be particularly valuable in uncertain environments like the one we find ourselves in today. With that said, uncertain environments can also create opportunities for high quality names to fall to more attractive valuations. 

How to Evaluate Dividend Growth Stock Opportunities

Below I have outlined 10 criteria to evaluate dividend growth stocks. Note that while we are seeking companies that possess a dividend yield, a high dividend yield  – dividend per share divided by the price per share – is not necessarily among the factors. On the contrary, companies that trade with high yields, particularly relative to their historic norms, should be approached with caution and give value to conducting a more holistic analysis. An abnormally high yield can be a valuable red flag depicting trouble at a company and the potential for a dividend to be cut. This is precisely what we will be trying to avoid through a disciplined, research based approach to find stocks that can not only maintain their existing dividends, but constantly increase them each year. 

To reiterate, identifying dividend growth stocks involves a careful evaluation of the company and dividend to ensure the health of the company, its potential for growth, and safety of the dividend. The metrics outlined below are used to that end and are considered in aggregate to depict an overall picture. This may, in turn, justify leniency in some cases for certain metrics. 

A Consistent History of Dividend Growth. To qualify as a dividend growth stock, a company must have a consistent history of dividend increases. This can be broken down into two fundamental criteria that a dividend growth stock must possess.

• +10 Years of Dividend Increases. A history of dividend increases is a critical factor, one that demonstrates management’s commitment to the dividend and the company’s ability to pay a dividend through economic cycles. Even 10 years may not be enough to satisfy my desire for demonstrated consistency, but it does well to act as a minimum threshold for consideration particularly if other metrics justify the potential for future dividend increases. 
• CAGR +5% Dividend Growth. Since we are not searching for a minimum yield, in addition to a consistent history of dividends, the dividend should have a CAGR of at least 5%.

Earning Growth. Since dividends are a portion of earnings paid to shareholders, therefore, consistent earnings growth is another fundamental criteria that a company must possess. 

• CAGR +5% EPS Growth. Earnings growth is the catalyst to fund future dividend increases; however, it may be prudent to be wary of companies that are growing earnings by more than 15%-20%. Companies that are expected to generate that type of growth are bound to disappoint at some point which may put the dividend at risk. 

Dividend Coverage. The safety of the dividend and potentially the affordability of future increases can be gauged using dividend coverage ratios including payout ratio and free cash flow to equity (FCFE) dividend coverage ratio. 

• Payout Ratio Below 50%. The payout ratio compares a company’s earnings to the dividend paid. With few exceptions, my threshold for dividend growth stocks is to have a payout ratio below 50% meaning that the company is paying 50% or less of earnings as dividends. This is important for two reasons: 

1. 1. In the face of a difficult operating environment, earnings may fail to grow or shrink. The higher the payout ratio, the more difficult it may be for a company to grow the dividend, or even sustain the current dividend. 
   2. The more a company pays to shareholders, the less it will have to reinvest in the business to grow earnings. As mentioned, earnings growth is an important characteristic of dividend growth companies. 

• FCFE Dividend Coverage Ratio >1. While there is research that demonstrates the merits of the payout ratio, it is important to be skeptical of the earnings per share number which is more susceptible to accounting manipulation. Further, dividends are paid with cash; therefore, we should be aware of how a company’s cash covers the dividend. One of my favorite metrics to determine dividend safety is the Free Cash Flow to Equity (FCFE) Dividend Coverage Ratio. FCFE is composed of cash from operations (including net income and working capital), capital expenditures, and net debt which shows the amount of FCF available to shareholders after debt payments. It is important for a company to be able to cover distributions (including dividends and buybacks) to shareholders with FCFE. Distributions in excess of FCFE would require a company to use other forms of capital to pay the dividend. Prolonged distributions in excess of FCFE could signal trouble for the dividend which justifies the importance for a ratio above 1. 

Reasonable Valuation. While valuation does not necessarily impact whether a company will pay their dividend or not, overpaying for a stock can be a costly mistake that wipes out the yield earned from dividends. A simple way to gauge value is to consider a stock’s P/E ratio and compare the P/E ratio to earnings growth plus the dividend yield (PEGY). While I am going to give general thresholds, it is worth noting that the multiples paid for stocks can be highly subjective. They can vary by market conditions, industry, company margins, and perceived risks.¹ 

• P/E Ratio Below 25. Generally, my threshold for the P/E ratio is 25x earnings. A stock more richly valued will have to live up to higher growth expectations to justify such a premium. That said, I would prefer stocks that trade below 20x. For companies that trade above 20x earnings, it is prudent to be skeptical and perhaps patient unless all other metrics are in place including your own due diligence justifying that earnings warrant a premium.
• PEGY Ratio Below 1. A favorite of Peter Lynch², the PEGY ratio compares the P/E ratio to expected earnings growth plus the dividend yield. For example, if a company has a P/E ratio of 12, 10% earnings growth and a dividend yield of 2%, the company’s PEGY would be 1 (12 divided by 12). Similar to the PEG ratio, the higher the PEGY ratio, the more investors are paying for earnings growth. 

Strong Balance Sheet. While evaluating a balance sheet can vary by industry, there are two metrics that I use to quickly gauge the strength of a company’s balance sheet – the current ratio and debt to EBITDA ratio.   

• Debt to EBITDA ratio below 2.5x. The debt to EBITDA ratio compares a company’s net debt (total debt minus cash and cash equivalents) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). It is used to assess the company’s financial leverage and its ability to service its debt. A high debt to EBITDA ratio may indicate that a company is heavily leveraged and may have difficulty meeting its debt obligations while the opposite may be true for a low ratio. As a result, I generally look for a ratio below 2.5x and, depending on the industry, potentially lower. 
• Current Ratio Above 1. The current ratio is used to assess a company’s short-term liquidity and financial health by comparing current assets to current liabilities. A ratio of 1 or higher generally gives me comfort that the company has enough current assets to cover its current liabilities.

Durable Competitive Advantage. A durable competitive advantage, also referred to as an economic moat, is a characteristic or feature of a company that allows it to sustain its competitive position and generate long-term value for its shareholders. Durable competitive advantages can come in various forms, such as a strong brand, a proprietary technology, a loyal customer base, high switching costs, or a unique product or service offering. The idea is that a competitive advantage creates a barrier for new competitors. 

A durable competitive advantage is, generally, not something that can be screened for and therefore involves a deeper understanding of the company in order to determine its existence. The value of a durable competitive advantage lies in the ability of the company to maintain its competitive advantage over a long period of time potentially translating into a higher market share, stronger profit margins, more stable revenue streams, and consistent dividend growth. 

Final Thoughts

Dividend growth stocks can be a valuable addition to any investment portfolio, as they offer the potential for long-term growth and a steady stream of income. However, not all dividend growth stocks are created equal, and it’s important to use a disciplined, research-based approach when evaluating potential investments. The 10 criteria described will act as a solid barometer for identifying companies that are likely to continue increasing their dividends over time and are better positioned to weather economic downturns. 

Keep an eye out for future articles that will incorporate these factors to evaluate dividend growth stocks, and identify dividend growth stock opportunities. 

Footnotes:

1. See my article, Demystifying the P/E Ratio, which goes into further detail into how to interpret the P/E ratio.
2. Lynch sought a PEGY ratio below 1.