Dividend stocks are companies that pay out dividends to its shareholders.
Thousands of companies pay dividends. However, not all companies have the ability to pay them consistently.
Today, I will present 5 criteria I use to identify quality dividend stocks:
- Solid franchise
- Consistency of margins
- Strong financial situation
- Dividend payout
- Dividend growth
I will use Johnson & Johnson (NYSE:JNJ), the gold-standard of dividend stocks, to illustrate each point.
A solid franchise is a company with a good business model who generates consistent profits.
You want to be on the lookout for well-established businesses who generate lots of cash they can redistribute to their shareholders.
How do you know if a business is a solid franchise?
One key characteristic of a solid franchise is its moat. A moat refers to a business’ ability to fend off competitors for an extended period of time. Think of a castle in medieval times: It was surrounded by a small body of water that prevented enemies from invading it. The company is the castle and the moat its competitive advantages that prevent competitors from stealing its business.
Johnson and Johnson is an American multinational corporation that develops medical devices, pharmaceutical and consumer packaged goods. With revenues exceeding $80 billion in 2019, they are a global leader in the pharmaceutical sector.
J&J’s economic moat is supported by intellectual property (patents) in the drug group, switching costs in the device segment, and strong brand power from the consumer group. They also boast an extensive sales force, huge R&D investments resulting in the launch of next-generation products and plethora of cash reserves to buy out promising start-ups and future market leaders. In sum, diverse revenue streams and the continued creation of new products essentially insulate J&J from the so-called “patent cliff” facing the pharmaceutical group.
An important criteria of a dividend paying company is the consistency and predictability of its margins. You want guarantees that the business model is sustainable and your dividend secure. You want steady growth in earnings and positive cash flow.
Looking at the balance sheet, you want to focus on gross margin, net margin, earnings and cash from operations of the past 5 years at least. You don’t want to invest in a company with erratic earnings and margins because they will not be able to guarantee consistent dividend payments.
The table below shows that JNJ’s average gross margin over the past 6 years is 68.02% and its average net profit margin 17.63%.
Generally speaking, net margins of 5-10% are considered low, 10-20% good and >20% exceptional. A company like JNJ who posts average net margins of 17% is quite impressive. Remember, we are looking for consistency and predictability.
Lastly, look at the free cash flow per share (FCF) to make sure it’s increasing. This metric is useful in evaluating how much a company can afford to allocate to both equity and debt shareholders As you can see in the chart below, JNJ’s FCF increases every year (with rare exceptions).
If you’re like me, you want to invest in financially healthy companies. Companies loaded with debt are one bad fiscal year away from cutting or eliminating your dividend. Not good. As an investor, we’re in it for the long term and we want security.
To determine whether the company’s financials are healthy, you want to look at the capital structure ratios to determine its solvency.
Referring again to our ratios chart, the first metric we look at is the current ratio. The current ratio is simply the comparison of the company’s assets versus its liabilities. A company with a current ratio of less than 1 does not have sufficient assets to meet its short term obligations whereas a company with a current ratio of more than 1 does. Here, we notice that JNJ’s current ratio is always above 1 and sometimes even above 2. This means that JNJ is solvent in the short term.
Then, we look at the company’s debt/equity ratio (D/E). This metric is used to measure whether the company is financing its operations with its own cash or with debt. In addition, D/E helps investors judge whether the company is able to pay off its debts in case of a downturn. High ratios tend to scare off shareholders as it signals that the company is relying on debt to fund its activities.
In JNJ’s case, the D/E is less than 1. This shows that the company is capable of self-financing its growth. The Long-term debt/Capital ratio is a variation of the D/E ratio and, once again, JNJ’s ratio is very low, indicating minimal debt burden.
The dividend payout calculates whether the company’s earnings are sufficient to support the dividend payment. A low ratio indicates that earnings easily cover dividends whereas a high ratio indicates that the majority of the company’s earnings is used to pay dividends.
A high ratio isn’t always negative because well-established companies have a tendency to distribute a greater portion of their earnings to their shareholders, while companies in the earlier stages of their development will prefer to invest their earnings.
You should be weary of young companies paying huge dividends before becoming mature as this is rarely sustainable.
Dividend Payout Ratio = Dividend / Net Income
Dividend payout Ratio = Dividend / Free Cash Flow
JNJ’s payout ratio is 42.29% which means that almost half of the company’s cash is distributed to its shareholders:
- 0%-35% payout: GOOD. Issued by companies who recently started paying dividends.
- 35%-55% payout: HEALTHY. The company is well established in its industry.
- 55%-75%: HIGH. A high payout is good for the investor’s pocket but also worrying because the company has less money to invest and grow the dividend.
- 75%-95%: VERY HIGH. This high signals that the company will struggle to invest and grow the dividend; a dividend cut may be near.
- >95%: UNSUSTAINABLE. A payout above 95% means that the company is distributing more money that it earns. One bad year could result in the elimination of the dividend.
In sum, you should always prefer healthy payout ratios because they are the most sustainable.
Dividend growth is crucial to generating income for your portfolio. A high dividend yield is fine, but you want dividends that increase along with the company’s earnings and cash.
Dividend growth is the annualized dividend growth rate and the number of years which the payout has been increasing. The annualized dividend growth rate is the yearly percentage increase of the company’s dividend payments. The number of years which the payout has been increasing is a key factor to determining whether the company is serious about rewarding shareholders.
The charts above provide valuable information to the potential investor: JNJ’s 10-year dividend growth rate is 6.87% and the company has raised its dividend every year for the past 57 years. These metrics show that JNJ is strongly committed to paying its shareholders their fair share of the profits.
How can we tell if the company can sustain the dividend?
To pay dividends, a company needs cash. Again, we need to look at the balance sheet.
The key metrics to look out for are net income and free cash flow.
JNJ’s net income peaked in 2016, dropped sharply in 2017, then recovered in 2018 and 2019. However, as you can see on the chart below, this did not have a negative impact on the company’s free cash flow. On the contrary, JNJ’s free cash flow keeps increasing.
Since JNJ’s free cash flow increases every year, investors can expect that JNJ will increase the dividend in the coming year, as they have done for the past half century.
If the stock you’ve screened passes all the tests, it is a prime candidate for investment.
The last thing you should consider before buying is the price of the stock and the dividend yield.
The dividend yield is the dividend expressed as a percentage of the current share price. Generally, a mature company’s dividend yield will be 2-3%.
If the stock price falls, the dividend yield increases, meaning that you will earn a greater return for every dollar invested. Conversely, if the stock price increases, the dividend yield decreases.
This is a useful metric that can be used to time your entry or dollar-cost average your position when the stock price fluctuates.
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Disclaimer: This is not financial advice. Always do your own research before investing in any asset.