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Dividend Investing: Key Metrics, Part 1

As Mark Lowe wrapped up chapter one of "Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks," he made a strong case for due diligence, even though dividend stocks are safer than many other types of stocks.

In chapter two, he provided nine key metrics and concepts that would guide an investor's due diligence, thus providing part of a road map for analyzing these stocks. We will look at the first four of them in this article.

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The dividend growth rate is also an integral part of the dividend discount model, a tool for valuing stocks by computing the present value of future dividends. In other words, it is a way of quantitatively calculating the intrinsic value of a stock.

To calculate the growth rate, using the dividend discount model, use the formula "P = D1 / (r-g)", where "D1" is the dividend value for next year, "r" is the capital cost of equity and "g" is the dividend growth rate.

Alternatively, an investor can use the "linear method," which involves the use of historical data. Lowe prepared this example with the following dividend payments per year:

  • 2015: $1.00
  • 2016: $1.05
  • 2017: $1.07
  • 2018: $1.11
  • 2019: $1.15



Feed that data into the formula: Year X Dividend / (Year X -1 Dividend) - A. That allows us to calculate the growth rates within those five years:

  • 2015: Not applicable.
  • 2016: $1.05 / $1.00 -1 = 5%
  • 2017: $1.07 / $1.05 -1 = 1.9%
  • 2018: $1.11 / $1.07 -1 = 3.74%
  • 2019: $1.15 / $1.11 - 1 = 3.6%



Averaging those figures, we arrive at an annual growth rate of 3.56%.

Dividend payout ratio

This refers to the percentage of profit that is transferred to shareholders by way of dividends. It can be calculated in two ways:

  • (Dividends per share / Earnings per share) x 100
  • (Total paid dividends / Net income) x 100



As the formulas suggest, this explicitly shows the proportion of earnings going to shareholders and, implicitly, the proportion being kept by the company as retained earnings.

For investors, the question becomes: How much can a company pay and still have enough to maintain and grow future profits? Or, how many feathers can you pick from golden goose before you kill it?

We're often cautioned to be wary of companies with very high dividend payout ratios. But Lowe warned that we need to do more research before deciding what's too much: "There's no single metric that can figure out if a payout ratio is good." He lists these examples:

  • Utilities, pipelines, telecom and other defensive sector companies enjoy stable and predictable revenues, so they can make higher dividend payouts.
  • Energy and other companies in cyclical sectors have unstable revenue and more trouble predicting future revenues, so they need to stick with lower payouts.



He also pointed out companies that prioritize growth will have lower payout ratios than mature companies; higher retention of earnings provides more capital to invest in future revenue.

Do be concerned about companies with a payout ratio of more than 100%; this means the company is paying out more than it makes. It also suggests the company may be in financial difficulty.

Conclusion

Due diligence is a critical part of buying dividend stocks. While these stocks are generally safer (bigger and more mature companies) than the broad market, investors do need to know their fundamentals.

In this article, we have examined four key ratios: the debt-equity ratio, the dividend coverage ratio, the dividend growth rate and the dividend payout ratio.

Assessing and understanding these ratios will help investors make better decisions when shopping for dividend stocks.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.