The most common problem for novice investors is they have no idea how to interpret all of the stats they can see for a particular stock. Imagine trying to play your Diablo 3 Barbarian and not knowing how Strength and Vitality affected your character. In Diablo 3, there are well over 50 different stat bonuses you can find on items, but really, there’s about 5 you should care about. The same is true for stocks. The most important valuation stats for dividend stocks are Growth History, Annual Yield, P/E Ratio, and Payout Ratio. These are the most important statistics to dividend investors like myself. Here is how I used them.
Growth History: Quality companies that distribute dividends regularly tend to raise their dividends consistently. I try to find stocks that have at least 10 years of dividend growth history. Meaning they have raised their dividend payment each year for the past 10 years or more. More than 10 years is an added bonus as I explained in the Hierarchy of Dividend Growth.
Annual Yield: The annual dividend yield is a percentage of the current price that is paid out each year in dividends. Really, the dividend payment is set, so the yield varies based on price. In the end, you’re always looking for a high yield when investing. I look for stocks with an annual dividend yield over 2% and below 7%. Stocks with yields over 7% are most likely failing one of the following guidelines, or are the result of a very strong downward trend and may continue to lose value.
P/E Ratio: This is the ratio of Price to Earnings Per Share (or EPS). Many people use the EPS to determine what a fair price is for a stock. I consider stocks with a P/E Ratio below 20 to be a good enough value to invest in. Stocks with high P/E Ratios are most likely overvalued.
Payout Ratio: This is the ratio of Dividends paid per share and Earnings Per Share (EPS). If a company earns 5 million dollars and pays out 2 million dollars in dividends each year, their payout ratio is 2/5 or 40%. I aim for stocks that have a payout ratio under 65%. Stocks with too high of a payout ratio, may not be able to afford raising their dividends each year, and may even need to cut their dividend payment. A dividend cut is like the mark of death for a dividend stock. Despite the name of this blog, you should absolutely sell a dividend stock that reduces its dividend payment.
I hope this helps shed some light on the way I value stocks and the important statistics for you to keep track of. How about you, how do you evaluate good stocks?