The Dividend Performance Indicator (DPI) is the product of the dividend yield and dividend growth rate. The DPI is a good way to screen for potential dividend stock candidates. I use current dividend yield and the 5-year dividend growth rate.
I also have a Modified Dividend Performance Indicator (MDPI) which gives more weight to dividend growth over current yield. It’s not as easy to calculate and as you probably know, I think these tools should be easy to use in order really help investors. You can start using the Dividend Performance Indicator as a quick way to screen dividend stocks. After you’re comfortable, check out the Modified Dividend Performance Indicator.
Who doesn’t love dividend stocks? They pay investors quarterly (sometimes monthly) without fail. And the real power of dividend stocks: GROWTH! A good dividend growth stock will increase the payout every year. The stock you buy that currently yields 3% will yield will grow to 6% in a few years and may double to 12% ten to fifteen years down the road. This is the yield-on-cost that increases every year.
You also want a decent current yield in most cases, although I put less weight in current yield and more weight in the dividend growth rate (see Modified Dividend Performance Indicator). Most investors say there is a sweet spot of current yield which is somewhere between 2.5 and 5%. Anything below this range will not pay you enough to make it worth owning. Anything above this range may have really slow growth or, if high enough, be in danger of cutting their dividend.
Dividend Performance Indicator Chart
You can also download as a Google Sheet here: DPI on Google Drive
I like a Dividend Performance Indicator of above 30. I feel that this gives you a good quick test to see if a stock is worth your capital. For example, a 3% dividend yield combined with a 10% annual dividend growth rate gives you a DPI of 30.
A stock that yields 3% and has a 5-year dividend growth rate of 4% would have a DPI of 12. This is too low. At a 4% dividend growth rate, your 3% dividend yield would only grow to 3.65% after 5 years.
We want a dividend growth rate of at least 10% if the current yield is 3%. A 10% growth rate would produce a 4.65% dividend yield after 5 years.
The Modified Dividend Performance Indicator (MDPI) takes it one step further by introducing a weighting to the growth rate. The weighting grows linearly as the growth rate increases.
Modified Dividend Performance Indicator Chart
You can also download the Google Sheet here: MDPI on Google Drive
I prefer the dividend growth rate to be high, even more than I care about the current yield on the dividend stock. So, I put a weight on the dividend growth rate. This means that with the MDPI, you can pick stocks with lower yields as long as the dividend growth rate is high.
A stock with a current yield of 2.5% and a dividend growth rate of 10.5% would give a MDPI of 32, which is acceptable. Under the regular DPI scale, a 2.5% yield and 10.5% growth rate would be too low to look at.
How to Choose Dividend Stocks
I use the DPI or the MDPI in order to screen stocks. That’s the first hurdle to clear. Then there are other factors to help you decide which dividend stock to buy.
1) Company earnings growth
2) Dividend payout ratio
3) Valuation metrics like P/E or EV/EBITDA
4) Company outlook
1) Company earnings growth – Earnings growth is important for all companies, not just dividend paying companies. I look for companies that have positive earnings growth of greater than or equal to the dividend growth rate. If earnings growth lags dividend growth for the long term, the company will either stop hiking dividend payments or may need to cut dividends! We don’t like cutters.
2) Dividend payout ratio – The dividend payout ratio is the ratio of the earnings the company pays out as dividends. A company paying out $1 / share in dividends annually that has an EPS of $2 annually has a dividend payout ratio of 50%. You can see what happens if the dividend payout ratio is too high. The company may not be able to raise dividends because they’d eventually be paying out more than they’re earning on a GAAP basis. Of course, a company could have a payout ratio of 120% and be just fine. Maybe they just took a one-time hit to earnings for whatever reason. I usually look at the trend of the payout ratio. If it’s really high one year, there’s probably a reason and it’s usually not a big deal. If their payout ratio is 90% of earnings every year, this may be unsustainable. (None of this applies to REITs or MLPs which are entirely different.)
3) Valuation metrics – Everyone wants a high growth stock with a low valuation. If you find one of these unicorns, let me know. I like valuations that are low enough to prevent a 50% drop in the stock price. Example – a stock with a P/E of 40 could easily miss quarterly earnings and drop big. I want some margin of safety where I’m buying a stock that has already pretty low expectations. I don’t want to pay up for hot stocks or anything. I’d rather buy ice-cold stocks that no one has heard of or big boring blue chips. I also prefer to look at enterprise value (EV) to Earnings Before Interest Tax Depreciation Amortization (EBITDA) ratio. This is how I would value a business if I were going to buy it so why would I value a stock any differently?
4) Company outlook – Investing is part art and part science. The science behind stock picking are the quantitative aspects. The art is the qualitative side. I used to frown on the art side. I wanted “just the facts.” This is the wrong way to think. I now look at the secular trends of industries. I look at management. I check to see how their brand ranks on Forbes. These are all things that I think you need to look at to get a holistic picture. I love brands, for example, and I’m willing to pay up for them. Brands allow for the company to charge a premium over generics.
5) Diversification – The last thing I look at when deciding which dividend stock to buy is how it fits into my portfolio. And this is the core holds portion of my Triad Portfolio where I hold individual dividend paying stocks, ETFs, and index funds. I want a diverse group of stocks overall. Different sectors, different market caps, a mix of growth and value, etc. The consumer staples sector is great for picking up dividend paying stocks, but you wouldn’t want all your stocks to be in this sector. Personal Capital has a really good allocation chart that shows you if you’re overly allocated to any given sector.
Dividend Performance Indicator Example
Let’s take a look at an example using the Target Corp (TGT).
Target Corp (TGT)
Current Dividend Yield = 3.65%
5-year Dividend Growth Rate = 14.87%
Modified Dividend Performance Indicator = 71
Initially, everything looks pretty good. We have a really high current yield compared to other stocks along with a 5-year dividend growth rate that is high too. This results in a MDPI of about 71 (use the chart in the above Excel file).
Earnings growth is pretty low at 5.8% average 5-year EPS growth as of January 2016. I set the bar pretty low anyway so this is not a deal breaker.
Target currently trades at a forward PE ratio of 12.2. This is historically low for Target and is due to another company: Amazon. Amazon is extremely competitive with big box retailers. Expectations for retailers with a bunch of physical locations is dreadfully low. Whether it’s JCP, Sears, Kohl’s, Target, Walmart, Best Buy, etc; they’re all getting squeezed. Amazon sees other companies profit margin as their opportunity.
Target passes the quantitative tests outlined above. There is some question as to whether Target is in an industry that is in secular decline. I think Target is still worthy of your capital as a small position in your portfolio. And this stock will present a buying opportunities every time Target’s comps are down or they miss quarterly earnings.
Investing in Individual Dividend Stocks for Retirees
There are many benefits to investing in individual stocks. Most people will point out that investing in individual stocks is risky. I disagree that individual stocks are risky but will concede that it can get complicated and isn’t for everyone.
Here are just a few benefits to owning individual dividend-paying stocks:
1) Zero ongoing fees to own…that’s 0.00%…nada!
3) Tax-loss harvesting is very easy with individual stocks
4) You’ll never be taxed on capital gains (don’t ever sell your winners)
5) Dividends are taxed at super-favorable rates: 0%, 15%, or 20% max depending on your tax bracket
6) Companies that pay dividends tend to raise them every year
7) Inflation protection due to rising dividend income
8) You can go to shareholder meetings and hobnob with smart folks like yourself
A retiree with core holdings of 20 individual dividend-paying stocks over different industries and market cpas is plenty diversify. Don’t let a broker tell you you have to be in ten different mutual funds, most of which just overlap anyway.
If you decide to invest in individual stocks, please let me know by putting your email in below and replying to my introductory email. What stocks are you interested in? Have you purchased yet? What types of things to do you look for when buying? Are you considering rolling over a 401(k) into an account you control? What made you take charge of your own finances?