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Analyzing P/E Ratios, Payout Ratios and Earnings Growth in Dividend Stocks

Apart from dividend yield analysis and relative strength, there are three key ratios that a dividend investor should look at while analyzing dividend stocks: P/E ratios, payout ratios and earnings growth estimates.

Below, takes a deep dive into how these three key ratios are unfolding across industries today, and how one should link them to dividend yield analysis and relative strength analysis.

P/E Ratios

When upgrades a stock to the BDS list we usually look at the price-earnings ratios (P/E ratios) across industries and then narrow down our analysis to individual stocks. We don’t necessarily believe that low P/E stocks are the way to go about investing when you are searching for dividend yields.

Think of P/E ratios as a proxy for analyzing dividend uptrends and the stock’s payout history. If a stock has been a serial dividend payer, one can’t expect the stock to be valued cheaply. If a stock is valued between 125% of the Dow Industrial average and the Dow Industrial average itself, we usually consider it a reasonable valuation for dividend stocks.

The important point is here is to not mix value investing with dividend investing. If you find a stock that’s valued very cheaply by the market and yet has a long history of paying dividends, then go for it. Otherwise, given the above calculation, a stock with a P/E ratio between 23 and 18 (Dow Industrial P/E) should be shortlist-worthy.

The current P/E ratios across industries reveals financials to be the cheapest compared to the overall average of 18.77 that we are observing across industries.

Utilities are valued slightly higher by the market, while basic material stocks are quite overvalued. Conglomerates is another industry which stands out. MMM (MMM ) particularly stands out in the industry as it trades at a forward P/E of less than 20.

Given the P/Es of conglomerates, utilities, industrials and REITS in financials, investors can narrow down their options as they go about creating their portfolios.

Payout Ratios

Payout ratios certainly aren’t among the first financial parameters that come to an investor’s mind as he/she goes about investing. But this parameter has tremendous predictability in terms of estimating future payout rates.

Current payout ratios reveal that utilities have the highest payout ratios on average and are least likely to grow their dividends going forward unless there is significant earnings growth. Financials have the second-highest payout ratios given that REITS are classified as a sector under financials. A 43% payout ratio still shows room for companies in the industry to grow dividends. The basic materials payout ratio is high due to low earnings estimates for 2016 which are causing the payout ratios to be inflated.

In terms of predictability, financials, and especially REITS, hold the edge over utilities in terms of maintaining a healthy payout ratio as there is still room left for them to achieve a 50% payout ratio, which we consider excellent for dividend stocks.

Earnings Growth’s approach to analyzing earnings growth is different from the general hypothesis that higher earnings growth estimates are better for a company and its stock price performance. A dividend-paying company is usually a well-established company that cannot possibly provide double-digit growth estimates year over year. Thus a company that’s providing modest estimates of between 2% to 10% should be appreciated over a company that’s estimating greater than 10% growth.

If the estimates are greater than 10% for the company you are analyzing, then it would help if you check out its payout ratios. A lower payout ratio correlates with higher earnings growth estimates because the company is likely reinvesting a large portion of its earnings.

The market usually slams companies that estimate high growth when there is blood on the streets because they tend to increase more than the market when there is a bullish rally.

High-beta companies should be avoided by income/dividend investors as they have wild fluctuations when the market goes up/down.

A company providing modest earnings growth estimates with a payout ratio that’s close to 50% should be preferred by dividend investors.

The above earnings growth estimates are currently observed across industries. Utilities and financials are in the range of growth estimates that we like, while basic materials are showing extremely high growth estimates.

The Bottom Line

Combining the logic for earnings growth, relative strength, payout ratios, P/E and dividend yield can help investors narrow down the sectors and the stocks in which they should be investing based on the current market conditions.

The five key parameters are currently pointing towards utilities, industrials and REITS/financials as good dividend-paying industries.

In an article that will follow, will analyze those dividend stocks within each sector that score high marks in the five key financial parameters we measured.