This is a guest contribution by Nick McCullum of Sure Dividend
For a new investor, figuring out the most important metrics to use in your investing strategy can be very difficult. There are a great deal of complicated financial statistics out there, and to make matters worse, many of them have vague acronyms like PE, PB, and EPS.
While they can be confusing at first, make no mistake – using metrics and statistics while investing is critically important. Investors are not able to truly assess the financial condition and growth prospects of a company without considering its financial data.
With that in mind, this article will list the most important metrics for dividend investors.
Dividend payments are the method used by a corporation to return company cash to its shareholders – the ultimate owners of the business. Dividends are declared by the company’s board of directors and are generally paid on a quarterly basis.
So why are dividend payments important? After all, the dollar value of a dividend payment is somewhat relative to the price of a company’s stock.
More specifically, a company with more shares outstanding (and a lower resulting stock price) will naturally have a lower per-share dividend payment. This means that comparing the dollar value of two companies’ dividend payments is not exactly meaningful.
However, dividend payments are important because they allow you to have a historical glimpse at a company’s dividend trend over time.
In general, it is a very good sign when a company raises its dividend each year for many years in a row. This signals:
- The business is performing well (i.e. earnings are growing at a sufficient pace to support a rising dividend payment)
- The company’s management is shareholder-friendly
In addition to these qualitative factors, there is quantitative evidence to support that companies with long histories of steadily rising dividends tend to outperform the broader stock market.
For one piece of evidence, consider the performance of the Dividend Aristocrats, a group of S&P 500 companies with 25+ years of consecutive dividend increases.
The performance of the Dividend Aristocrats is compared to the performance of the S&P 500 below.
Clearly, companies with steadily rising dividend payments tend to outperform the broader stock market.
Why is this?
A business needs a durable competitive advantage in order to increase its dividend each year for 25 years in a row.
Along with allowing the business to increase its dividend for many years in a row, a strong competitive advantage also helps the business to expand its operations, grow earnings-per-share, and boost shareholder total returns.
The dividend yield is a metric that shows how much dividend income is generated for each dollar invested into a particular stock. The dividend yield is calculated by dividing a company’s annual dividend payment by its current stock price. The dividend yield is expressed as a percentage.
Dividend yield is important because it allows investors to construct a portfolio to meet a certain income goal.
However, it can be very tempting to chase high yield dividend stocks. While there are certainly some high yield dividend stocks that make very worthwhile investments, there are others that are paying a dividend in excess of their earnings and may cut their dividends in the future.
Importantly, it is actually the fourth quintile of dividend payers (those in the 60th-80th percentile) that have delivered the strongest total returns over long periods of time.
This suggests that investors seeking total returns should invest in stocks with relatively high dividend yields, but not the very highest dividend yields.
To understand shareholder yield, an investor must understand share repurchases. Companies have the ability to repurchase their own company stock to reduce the number of shares outstanding and improve important per-share financial metrics like earnings-per-share, revenue-per-share, and free-cash-flow-per-share.
Just like when buying stocks for investment, the price that a company pays for its own stock is very influential on the value-creating capabilities of a share repurchase program. Paying too high a price in a share repurchase program will destroy shareholder value.
This suggests that the best time for a corporation to repurchase stock is during a recession.
Unfortunately, this is the opposite of what happens. Share repurchases declined noticeably during the last major recession of 2007-2009.
Source: O’Shaughnessy Asset Management
To determine how much capital a company is using to repurchase its own stock, we can calculate a ‘share repurchase yield’, which is simply the per-share dollar amount of money spent on share buybacks divided by the company’s stock price.
Adding share repurchase yield to dividend yield gives shareholder yield, which shows how much money (in total) is being returned to shareholders through dividend payments and share repurchases.
Shareholder yield is important because it shows how much money a company’s management is returning to its shareholders on a holistic basis (not just via dividends). Some companies (Apple comes to mind) have relatively low dividend yields but very high shareholder yields.
A higher shareholder yield indicates a more shareholder-friendly company, all else being equal.
The price you pay for a stock has a profound effect on the future returns of your investment. The price-to-earnings ratio is the best metric to determine the relative value of a publicly-traded common stock.
As its name suggests, the price-to-earnings ratio is calculated by dividing stock price by earnings-per-share. It is important to use adjusted earnings-per-share (which backs out one-time charges such as those associated with an acquisition) to get a true sense of a company’s real earnings power. A lower price-to-earnings ratio results in superior future returns, all else being equal.
When calculating a company’s price-to-earnings ratio, it is important to compare it to two benchmarks.
First, compare the company’s current P/E to its historical P/E. This gives a sense of how the company is valued relative to its historical norms.
Secondly, compare the company’s current P/E to the current P/E of its peer group.
Using both of these comparisons can help to identify high-quality businesses trading at fair or better prices, suitable for long-term investment.
The payout ratio is the single most important measure of dividend safety. It is calculated by dividing a company’s annual dividend payment by its annual earnings-per-share. Alternatively, a quarterly payout ratio can be calculated by dividing quarterly dividend payments by quarterly earnings-per-share.
The payout ratio is expressed as a percentage and shows what proportion of corporate earnings is being distributed as dividend payments. High payout ratios (particularly those above 100%) may indicate that a dividend cut is on the horizon.
Quantitative metrics an integral part of a successful investing strategy. Sure Dividend uses some of the most important metrics from this list as part of The 8 Rules of Dividend Investing, a systematic strategy used to find high-quality businesses trading at fair or better prices to buy now and hold for the long-term.
So how can you use financial metrics in your own personal investment strategy?
In general, look for companies with rising dividend payments, above-average dividend yields, share repurchase programs, low P/E ratios, and low payout ratios. These metrics allow you to understand a company’s financial position and make better investment decisions in the future.