Identifying an undervalued dividend stock to add to your portfolio is an exciting task for dividend investors. As an accountant, I naturally try to set parameters to mitigate risk. When looking for a new addittion to my portfolio I consider two factors; is the stock over/undervalued and is the dividend safe. However, there is no golden rule to figuring out these two answers.
This is why I set some simple dividend stock parameters to help identify undervalued, and safe, dividend growth stocks. Once the stock passes all parameters I put on my hard hat and perform in-depth analysis. My four metrics are as follows:
Parameter #1: Price to earnings (P/E) Ratio
The price to earnings ratio is widely used by many investors to determine how a stock is valued. While this metric certainly has many flaws, it is a quick way to glance at a stock and figure out if it may potentially be undervalued. I often see many investors put a set number on this parameter. Some may say a P/E less than 20, or a P/E less than the S&P 500 shows signs of potential undervaluation. However, I highly disagree with this method.
The simple reason is that every industry has a different P/E. Autos and banks often have a low P/E due to consumer sentiment, technology often has a P/E higher than the S&P due to their high growth and consumer stocks are valued around the S&P 500 P/E. Example, if I am screening a consumer stock, I know that the S&P typically has a P/E ratio of 18-19 (higher now that we are in an overvalued market). With this in mind, I will look for stocks somewhere in the 15-16 P/E range for potential undervaluation. The key word here is potential. Each stock has a historical P/E that I would further look into if it passes all parameters. This metric is simply to identify companies to consider.
Parameter # 2: Current & Historical Yield
It is important for my portfolio to include companies with dividends. The second parameter I look for is the yield of the company. Most commonly, I look for companies with a starting yield of 3.0% or greater as I would like my portfolio to have an average yield of greater than 3.0%. Should a company have a yield below 3.0% I would refer to parameter #3. Companies with a yield over 5% are often a red flag to me. These companies usually have a high payout ratio (Parameter #4).
However, there are times where companies are unfairly punished in the market which causes their price to drop and their yield to rise above this threshold. One example is a REIT I recently bought that had a 3.2% historical yield but is now yielding 5.3%. This is often a sign of undervaluation which would lead me to do more research on the company and the industry they operate in.
Parameter #3: Dividend Growth Greater than 7%
Unlike the P/E ratio that varies per industry, I apply the 7% dividend growth to most companies. The only industries that I give exception to are utilities and telecom. These sectors are usually mature with little room for growth so I look for growth greater than inflation as they typically yield 4%+. You can easily find the 3, 5 and 10-year dividend growth on most financial websites.
If a stock has a yield lower than 3% I look for dividend growth above 10% due to parameter #2. Lowe’s is a perfect example of this as they currently have a yield of 1.75% but have been growing their dividend by an average of 21.12% over the past 5 years. I believe it is important to have these companies in your portfolio as your yield on cost will likely be higher on these stocks in the future than a company yielding 4% with 3% dividend growth. Of course, maintaining those aggressive growth rates will not last forever but it usually signals a low payout ratio.
Parameter #4: Payout Ratio
Last but not least is what I believe to be the most important parameter, the payout ratio. The payout ratio is the proportion of earnings paid out as a dividend to shareholders. If a company has a high payout ratio they often cannot sustain their dividend. There is a high correlation between payout ratio and dividend cuts which make this a crucial metric.
Through research, reading, and talking to other investors I believe a payout ratio less than 70% is healthy for a company. However, it is important to remember that each industry and company are different. Utilities, REITs, and telecoms often have payouts higher than this benchmark. I would compare these companies to their historic average and the industry.
If a payout ratio spikes above 70%, eg. 67% the year before and 77% this year, it is often a warning sign that requires more research. The energy industry is currently an example of this as many energy companies have seen their top line reduced due to lower oil and gas prices. If a company has a payout ratio greater than 100% it is a major red flag that their dividend is unsustainable. I would urge you to stay away from these companies.
While these four parameters are great for identifying undervalued dividend paying stocks, in-depth research should always be done. You should understand why is the company down, how is the industry performing, how the company will grow in the future and more. Historical performance does not dictate future growth but these parameters help weed out some of the dangerous investments.