Published August 17th, 2017
This is a guest contribution by Jay Delaworth of Intelligent Trend Follower.
Investing in dividend growth stocks is a great way to snowball your wealth for the long term. But like most things worth doing, it can be easier said than done. That’s why I want to share three financial statement red flags you should watch out for if you’re going to be investing in stocks with growing dividends.
Of course, by no means are these three tips a cure-all for dividend growth investors. But hopefully they can help you avoid some of the most expensive mistakes, which will leave you more capital to compound for decades to come!
Tip #1 – Check the Cash Adjusted Payout Ratio
I promise you that while sharing these tips, I’m eating my own cooking. And this first tip is one that I always do before buying shares of a company with dividend growth potential. The reason is simple.
If a company is issuing a dividend that is not currently covered by operating cash flows, well, that’s pretty risky! Without sufficient cash being generated from core operations, companies can’t issue sustainable dividends. While management may promise shareholders the world, when push comes to shove they can leave you out in the cold.
So that’s why I always pay attention to the cash-adjusted payout ratio. While you’re likely familiar with the payout ratio (percentage of net income being paid out in dividends), I like to use free-cash-flow instead of net income.
This is because with regular GAAP accounting, companies can realize income in a variety of different ways. And this means they’ll sometimes obscure the payout ratio or make it look better than the underlying operations might suggest. So that’s why I always like to check out Morningstar.
They have a ton of great free data available. Here’s an example with Apple (source).
As you can see above, the Apple stats show a company with strong cash flow to cover the dividend. In the most recent year, the free cash flow was more than four times than the dividend. And since I’m familiar with Apple’s business, I can be confident these cash flows are likely to continue.
On the other hand, if this was a company I hadn’t seen before, I would probably dive a little deeper into the cash flow statement to confirm money is being regularly made from operations. And once again, Morningstar makes this easy! You can just click on the Financials tab at the link above to pull up the cash flow statement.
Finally, the exact payout ratio threshold you use to disqualify stock picks is up to you. I like to look back over the last few years and avoid stocks when the number veers over 60%. I think you need to leave a little wiggle room like that if you want to invest for dividend growth.
Tip #2 – Look for Other Consistent Fundamental Trends
Since we have the key stats from Morningstar up on our screen, I always like to look a little bit deeper. In particular, by looking at the combination of top-line revenue, margins and per share income, you can get a feel for the consistency of the business. And as dividend growth investors, consistency can give us peace of mind that the distributions will keep getting bigger.
In fact, you can even copy and paste the Morningstar data above into Excel and quickly put together a simple graph. This only takes a second and is a great way to visualize the longer-term operating trends that drive the share price and dividend growth over time.
Once again, shares of AAPL stack up pretty good, right? You can see that not only is income increasing, but margins have been pretty steady, too. Meanwhile, top-line sales continue to trend higher. When investing for dividend growth or writing about investing ideas each week, this is exactly the kind of characteristics I want to see!
Even though these stats are backwards looking, they do provide some reassurance that management is doing a good job in allocating capital, growing distributions to shareholders and, most importantly of all, running the underlying business well! This kind of performance doesn’t happen by accident.
And when all these performance metrics add up, I’m particularly encouraged. Companies that are growing sales usually have more room to grow their dividends as well. And this is especially true if they’re doing it at consistent (or improving!) margins. Plus, when the per-share results are consistent you can be more confident that you aren’t going to get diluted, even further improving the chance of growing your dividend per share.
This is especially useful for companies that only started issuing a dividend more recently, and might not have a long track record of payout ratios you can examine. But by looking at the financial and operating trends in the underlying business, you can start to infer whether or not the company will be able to maintain and grow their dividend.
There’s just one more thing you need to watch out for…
Tip #3 – Never Ignore the Capital Structure
As equity investors, we often have a lot of stock market information at our fingertips. But there’s more to dividend growth analysis than the number of shares outstanding. And that’s why I never buy a potential dividend growth stock without looking at the balance sheet.
Once again, Morningstar provides great historical data for free. Here’s an example of where you can find the balance sheet, once again using Apple (source):
In the case of AAPL, you can see that overall things look pretty good. While they have been issuing long-term debt, they do have a ton of cash on hand and could easily cover the interest. Nonetheless, if you are a little concerned by what you see, you can pop over to the income statement and quickly look at how income expense compares to income.
Personally, I start to get nervous when companies are paying more than 5% of operating income as interest expense. That’s because as an investor hoping for growing dividends, I don’t want other people making claims to my cash flows! And as you probably know, debtors are higher in the capital structure, which could threaten your dividend.
Another thing to watch out for is preferred shares. These special shares can often pay a hefty dividend, and unlike common shareholders their dividends are guaranteed. Yikes! And while warrants and options can also dilute you, in my experience they’re a little less common with great dividend growth companies.
Conclusion: Augment Your Dividend Analysis by Avoiding Red Flags
It’s like the old saying goes: The best offense, is a good defense! So if you can avoid tying up your money in unprofitable companies that can’t pay consistent dividends; and instead, compound your cash on a regular basis with growing distributions, you’ll be racing towards financial freedom much faster!
I know these tips aren’t definitive. But I hope you find them helpful. I believe they can help you improve your analysis by avoiding expensive mistakes, which will have your money working for you even harder.