Mastering the Dividend Drill

Jeremy Glaser: From Morningstar.com. I am Jeremy Glaser: What's the best way to evaluate dividend stocks? Morningstar DividendInvestor editor Josh Peters is here today to answer this question.

Josh, thanks for talking with me today.

Josh Peters: Thanks Jeremy, good to be here.

Glaser: So, for someone who is taking a look at a stock and primarily wants to get yield from it, what are the steps that he should take in order to evaluate it?

Peters: Well, my process is really based on the idea of getting the questions right and knowing which questions to ask about a specific business when you're looking at it for the first time and then subsequently as you're evaluating it. Those questions are, if anything, more valuable than the answers. Anytime you make an investment, no matter how conservative or how much you are trying set aside speculation, you are making projections about the future because that's where your profits lie. Your dividend payments, your capital gains, everything.

In order to frame the question about the uncertain future, I think you have to have a good questions. And that's why about six years ago, when DividendInvestor was still very new, I broke the whole process down into three questions that I call my Dividend Drill. All of the three questions are about the dividend. That's mostly what I'm interested in; that's what I expect not just to provide income but also drive the stock performance. So I ask: Is the dividend safe? Will it grow? And what's the return?

Glaser: So let's start with safety. How do you evaluate if a dividend is going to be safe or not?

Peters: Well, there are lots of factors to look at. There are certainly as many situations at least as there are different companies out there. But I could break it down into kind of three big areas that you definitely need to pay attention to.

One is the balance sheet because you have to be comfortable that the company is more than capable of meeting all of its obligations to bondholders or banks, employees, suppliers, even the IRS, in order to know that there is going to be money left over to pay dividends. So evaluating the financial strength of the company is very important. One thing, newly introduced over the last year or so that I think could be helpful is Morningstar's credit ratings. If you are looking at BBB- or better for Morningstar credit rating--that's expressing that we're fairly comfortable with the company's ability to pay bondholders--that also will generally give you a good start toward finding a safe dividend.

A second factor to look at is just whether or not the business is growing or shrinking. You are kind of either being born or you are dying in the business world. A buggy manufacturer, might have a fantastic balance sheet and very low payout ratio; more than the second. But if the business is shrinking, it may not be able to sustain that dividend long enough to make it a profitable investment. So you really want to find businesses that in a secular sense--that is, strip out effects of economic cycles--are at least stable and preferably have some potential to grow.

And then third point is just looking at the payout ratio. How burdensome is the current dividend on the company's finances? How much room is there for, say, earnings to drop in a recession? Or what if there is some short-term bad thing that comes along to hammer profits while still leaving you with your dividend intact? That you have to view in terms of volatility of the business. It's very common for utilities to have say 60%-70% payout ratios, 60% or 70% of their annual earnings going out to shareholders as dividends. That's generally a pretty safe mark because even in a recession, their earnings don't drop that much.

If you're looking at a steel mill, there may be no payout ratio that's low enough to really say that it's going to be safe or an oil refinery, because at the bottom of their cycles they lose money, and they may not be able to part with any cash to shareholders at all.

Glaser: We look at the next question which is, if they raise the dividend how do you gauge that effect?

Peters: Well, that I can break down into two pieces, the first is the question can they raise the dividend, can they grow the dividend? And that's really a function of: Is the business growing, how fast, what are their opportunities to reinvest and expand their business over time? It can take some different forms. I mean take Altria Group, one of my favorite companies. The stock's not really attractively priced right now, but its certainly what I think is a good long-term hold. Everybody knows that smoking is in decline, and Altria, now after having spun off its other units, is really pretty close to a pure play on domestic tobacco, mostly cigarettes. As that shrinks, what does that mean for future? Well, if they can raise prices fast enough to more than offset that, that's a business that can actually grow. So you may have to be a little bit creative about the way that you look at that, but the bottom line is, their profits have some potential to grow. Another piece is capital allocation; does the company have opportunities to reinvest in its business? For a utility, it might be building new power plants that are more efficient to replace old ones. They have more money at work, so regulators allow them to collect more from customers.

One of my favorite companies, which is kind of the polar opposite of a utility, is Abbott Laboratories. This is a company that is benefiting from very long standing and very durable trends in health care. Yes, there is lot of pressure on health-care costs coming from governments and insurance companies, but people are living longer. In emerging economies, people have more money to spend, and that's a quality-of-life issue. As long as Abbott continues to churn out products like Humira or a Xience stent that materially improve the quality of people's lives, lengthen them and provide a better quality of life, then demand for that business should be rising. And Abbott has a lot of different lines of business to invest in. It could be Similac Baby Formula, such as adding a new line there, or it could be some new drug development I couldn't even begin to rephrase because I don't have a Ph.D. in medicine.

Put that all together, and I think you have a good growth profile where it becomes the will-it-grow question: Does management actually reward shareholders directly for the growth of earnings?

Not all companies do. In Abbott Laboratories' case you have almost four decades now of dividend increases on an annual basis. That tells me a lot about the way management is looking to reward shareholders.

Glaser: The final question is how do you think about the total-return potential from a dividend stock?

Peters: To me it really breaks down into two components. Again you're kind of doing this decision-tree type of logic. The ultimate answer from the is-it-safe question is really the dividend yield. To continue with Abbott Labs, at roughly 4%, do you think it's safe? That's kind of the part A. Part B is the growth component, which I think Abbott can raise its dividend about 9% a year, which is a very good rate of growth even if you didn't have that big of a yield. Add those two factors together, and you have 13%. I think that's a very good overall total return. And to the extent that in the long run the share price should follow the dividend up or down, that 9% growth in the dividend on a yearly basis should correlate to roughly 9% a year in capital appreciation. If you start off with a stock that's undervalued, which we think Abbott is by quite a bit, you may even do a little bit better than that.

Now how much return is enough? I generally use 9% or 10% as kind of a bottom-end scenario. You should look at the more safe the company is, the more reliable its business is, and the larger its current dividend is, which takes a little emphasis off of that growth component to drive total return. I might be comfortable settling for a little less. If I'm looking at something where the yield is pretty low but there is a lot of growth potential, maybe it takes like 13%-14% to really get me interested.

At the final end of the spectrum you find a company like one of my favorite little utilities, Piedmont Natural Gas, which has dividend growth at about 4% a year. That's a great business, but I think the stock is too highly priced. It doesn't provide enough current income for me to really take an interest there.

Glaser: Josh, thanks for giving us these tools.

Peters: Hope it provides some good questions to ponder when people are out there looking at stocks. It's not easy, but we try to make it easy.

Glaser: Thanks Josh. From Morningstar I'm Jeremy Glaser.