For dividend-focused investors, finding the best stocks that will ensure years of rising dividends and returns takes a fair bit of legwork. It also takes a bit of know-how to ensure that the stocks you choose will keep those dividends going over the long haul. There are plenty of data points and metrics to an individual stock that need to be considered.
On each stock’s ticker page on Dividend.com, we hone in on the five most important components dividend investors should about. These include the following:
- A stock’s dividend yield, which is the dividend expressed as a percentage of a current share price.
- A stock’s payout ratio, which is the proportion of earnings paid to shareholders in dividends.
- A firm’s dividend-growth history, which is the number of years it has steadily grown its dividend payout.
- A firm’s annualized estimated earnings per share (EPS) provides an estimate of how much money it is expected to earn next year. This forms the basis with which to calculate the firm’s annualized payout or the estimated amount of dividend the firm is going to pay throughout the upcoming year.
- The final component is our proprietary DARS model. To learn how it can make you a better investor, read the following section where we describe how it works.
All of these metrics can be found near the top of the ticker pages on Dividend.com and are labeled “Stock Dividend Data”. They look similar to this screenshot from healthcare giant Johnson and Johnson (JNJ ).
DARS Does the Work for You
As we said at the beginning, it takes a lot of work to dig into a stock and see if it has what it takes to be a dividend champion and not a dividend chump. Here at Dividend.com, we make it easy for you. Our proprietary Dividend Advantage Rating System (DARS) uses a sophisticated algorithm to rate each of the nearly 7,000 stocks on our site. The model uses all five of the primary dividend metrics as well as a stock’s relative strength or momentum to find the answer to a simple question: Is this dividend stock a buy or a sell?
If you know the DARS rating of a stock, you don’t need to look at any other number as a dividend investor. It allows you quickly compare thousands of investment opportunities to find the perfect fit for your portfolio. However, the system is not a call to buy or sell a particular stock; it’s a tool to help drive those decisions.
Building-Out the DARS Model
DARS uses input from all the key metrics to compile its final score. The key data points listed on every ticker page are divvied up into various categories and then averaged to provide the final number. Those categories are: Relative Strength, Yield Attractiveness, Dividend Reliability, Dividend Uptrend and Earnings Growth.
Relative Strength: Relative strength looks at how well a stock is performing with regards to share price and upward trends. We calculate relative strength by measuring the % change from the stock’s 52-week high. The number will always be negative.
The reason why a stock’s forward momentum is important is that it indicates that investors are valuing a firm’s growth prospects and that it isn’t just an “income play” or value opportunity. Stocks that continue to move forward and higher provide the best combination of dividends and capital gains for a high total return.
Overall Yield Attractiveness: Believe it or not, a higher yield isn’t always a good thing for investors. Those stocks with dividend yields just above the broader market averages such as the S&P 500 or Dow Jones Industrials offer the best hunting ground for dividend seekers. This slightly higher yield indicates that there are still growth opportunities for the underlying businesses. But, at the same time, management cares about its shareholders by returning profits via dividends.
Too high of a yield might mask problems with a stock. Business-based problems may have pushed share prices lower, thereby raising its yield. Investors often feel they need the higher dividend in order to feel compensated for owning a riskier stock. At the same time, a higher yield could mean that growth is gone from a stock and management is using its dividend to attract so-called “yield tourists” to a floundering business.
To calculate the yield on a stock, our DARS model takes the annualized payout and divides it by the current share price. Since we are looking for dividend growth and future potential, the yield information and annualized payouts are forward-looking.
Dividend Reliability: Newton’s first law of motion states that “an object in motion stays in motion.” This can be applied to dividend investing as well. Firms with long histories of dividend raises tend to keep those streaks going. Part of the reason they are able to keep them alive comes down to the percentage of their profits they hand back to investors. It’s called the payout ratio and it has a big bearing on how much and how often they can increase their dividends.
A stock’s payout ratio is its annualized dividend divided by its annualized EPS estimate. This number is important because it shows what percentage of a firm’s profits are being used for dividends, buybacks and other shareholder rewards. In our example, JNJ has a payout ratio of around 45%, which means for every dollar it makes in profits, 45 cents is handed back to shareholders as a dividend. That means there is still 55 cents left for additional growth initiatives, additional dividend increases or other activities.
A low payout ratio is an easy way to determine a stock’s future potential for higher dividends down the road.
Dividend Uptrend: “Price is what you pay, but value is what you get” is a famous Wall Street adage. One of the easiest ways to find “value” is through a stock’s price-to-earnings (P/E) ratio. For our DARS model, we calculate a forward P/E by taking the current stock price and dividing it by the current calendar year EPS estimate.
Looking at a stock’s P/E is important when valuing its prospects. The model favors stocks with lower price-to-earnings ratios as it shows the best combination of value and growth. Stocks with P/Es too low could indicate that investors have abandoned the stock completely and it is only suited for deep value hunters. Meanwhile, stocks that are too expensive might suggest that traders are only looking for growth out of the firm. By focusing on stocks with P/Es within a tight range, investors get the best combination of “growth and income” from their investments.
Earnings Growth: While firms can do all sorts of “tricks” to pay a dividend – spend cash reserves, use debt, etc. – the real “meat & potatoes” of payouts comes down to making more money than they need to operate. Earnings and the continued growth of those profits are what really drive dividends. So, looking at a firm’s earnings growth is very important, and that calculation involves forward-looking numbers. We calculate earnings growth as a stock’s next calendar year EPS estimates divided by current calendar year EPS estimates.
Much like dividend yields, higher isn’t always better when it comes to earnings growth. Stocks with high single-digit earnings are favored by the model as it indicates steadiness of profits. That slow-and-steady pace is what strong dividends are made of. Companies with continued double-digit EPS growth numbers are fine, but they tend to be valued by investors for that growth and not for their dividend potential. At the same time, stocks with continually bumpy earnings – those that shift between profits and losses – tend to not have the strongest dividend histories.
In the end, steady profit growth translates into steady dividend growth.
Putting It All Together
Using these five major dividend metrics, our DARS model was born. DARS assigns a score for each of the parameters based on our algorithm that shifts with market trends. The model then averages the scores for each of the metrics to get the final DARS rating. For example, stock XYZ has a Relative Strength score of 4, a Yield Attractiveness score of 3, a Dividend Reliability score of 4.5, a Dividend Uptrend score of 2.4 and an Earnings Growth score of 4; its final DARS rating would be 3.6.
This rating can be used in your analysis to buy or sell a stock accordingly. It makes it easy to compare a variety of stocks and sectors in an instant. Stocks with higher DARS scores should be given preference over those with lower ones. And the cream of the crop makes it onto Dividend.com’s coveted Best Dividend Stocks list.
Nonetheless, there are many factors that go into security selection. DARS makes the dividend/earnings portion of that selection easy. However, the model is not a clear cut “buy” or “sell” signal. It’s a piece of the puzzle when figuring out how to build your portfolio.
The Bottom Line
There’s a lot of financial jargon and parameters that go into picking the best stocks. Our DARS model and rating guide does the hard work for you. It combines five of the key metrics used in stock selection and boils them down to an easy-to-understand number. Investors can then use that number to help build their portfolios accordingly.