03-29-2013, 08:23 PM
So far in this series of posts, I’ve discussed several important criteria that I (and lots of other DG investors) use to evaluate a dividend growth stock. I have failed to mention that I am not taking these criteria in any particular order, and generally believe that all of these factors must be considered together. However, had I meant to start with what I think is the most important criteria of all, I might have started with earnings.
It is perhaps an obvious point, but without earnings, you can’t have a profitable business capable of paying out some of those profits to owners (shareholders) in the form of dividends. The health and trajectory of a company’s earnings tells you a lot about the ability to pay dividends and to raise them in the future. So you’ll want to get comfortable looking at a company’s earnings, as well as the growth rate of those earnings. What a DG investor loves to see is a steadily growing earnings stream supporting a steadily growing dividend. When earnings and dividends grow in tandem, the dividend can increase every year while keeping the payout ratio steady. (And the icing on the cake is that in this case, you can expect the share price to follow right along!)
An unfortunate point about earnings is that they can be a bit hard to pin down. Unlike concrete measures that cannot be fudged (such as the current stock price, or the dividend payout), reported earnings can be the result of complex calculations by the company and are not always completely transparent. In the best of cases, the company makes an honest and conservative calculation of the numbers and achieves a reliable result. In the worst of cases, earnings can be “tweaked” in the face of pressure to meet estimates, or even subject to outright manipulation. (Is Enron still in our collective consciousness?) Furthermore, earnings can be subject to restatement in quarters after they are initially reported. It is not uncommon to see different earnings figures for the same period in subsequent annual reports.
This shouldn’t cause too much worry to dividend growth investors, though. Dividends are a real payout of money that enforces discipline on the company. A company cannot write dividend checks to shareholders from earnings that it made up – not for long, anyway. Also, many favorite dividend growth companies operate relatively simple, transparent businesses. While of course Procter & Gamble (PG) could cook its books, I am comforted that they make hundreds of products that I can see people buying and using every day. Similarly, there is no question that KO is moving its product.
In evaluating earnings, I look at the five-year average, the one-year numbers for the past few years, corporate guidance about upcoming periods, and at analyst expectations. (I generally put little faith in analyst expectations, but they can be valuable in some circumstances, such as alerting me to a reason I was unaware of that earnings might depart significantly from recent trends.) As with other metrics, some dividend growth investors adhere to rules about what sort of earnings growth they must see before investing in a company. As I’ve said before, this can be helpful in imposing disciple on an investor, but personally, I prefer to look at the whole story together. Of course I prefer a company with steadily growing earnings, but I will not rule out a company with flat earnings if, say, the payout ratio is low and I believe the company will be able to grow earnings in the future. Also, it is worth noting that earnings can be volatile as a company’s various products fall in and out of favor or as the general economy stalls or thrives.
Intel is a great example of this. If you look at the past five or six years generally, INTC’s earnings growth has been good. But in the past couple of years, it has stalled and is even moving in the wrong direction. Most of the headlines about this suggest that INTC is being hit by the one two punch of missing the boat on chips for mobile devices combined with the death of the PC. A hard and fast rule about a minimum earnings growth rate might exclude INTC as an investment on this basis. But if you believe that INTC is making the right moves to get earnings back on track, this might be an excellent time to get in. On the other hand, if INTC cannot get earnings back on track, their long term ability to continue to raise the dividend at a healthy pace might be compromised.
Whether or not you apply a hard and fast rule about earnings growth, earnings are the lifeblood of the company and the source of the dividends, and so must be monitored very closely.
In the next installment of this series, I’ll discuss the P/E ratio and valuation generally.
It is perhaps an obvious point, but without earnings, you can’t have a profitable business capable of paying out some of those profits to owners (shareholders) in the form of dividends. The health and trajectory of a company’s earnings tells you a lot about the ability to pay dividends and to raise them in the future. So you’ll want to get comfortable looking at a company’s earnings, as well as the growth rate of those earnings. What a DG investor loves to see is a steadily growing earnings stream supporting a steadily growing dividend. When earnings and dividends grow in tandem, the dividend can increase every year while keeping the payout ratio steady. (And the icing on the cake is that in this case, you can expect the share price to follow right along!)
An unfortunate point about earnings is that they can be a bit hard to pin down. Unlike concrete measures that cannot be fudged (such as the current stock price, or the dividend payout), reported earnings can be the result of complex calculations by the company and are not always completely transparent. In the best of cases, the company makes an honest and conservative calculation of the numbers and achieves a reliable result. In the worst of cases, earnings can be “tweaked” in the face of pressure to meet estimates, or even subject to outright manipulation. (Is Enron still in our collective consciousness?) Furthermore, earnings can be subject to restatement in quarters after they are initially reported. It is not uncommon to see different earnings figures for the same period in subsequent annual reports.
This shouldn’t cause too much worry to dividend growth investors, though. Dividends are a real payout of money that enforces discipline on the company. A company cannot write dividend checks to shareholders from earnings that it made up – not for long, anyway. Also, many favorite dividend growth companies operate relatively simple, transparent businesses. While of course Procter & Gamble (PG) could cook its books, I am comforted that they make hundreds of products that I can see people buying and using every day. Similarly, there is no question that KO is moving its product.
In evaluating earnings, I look at the five-year average, the one-year numbers for the past few years, corporate guidance about upcoming periods, and at analyst expectations. (I generally put little faith in analyst expectations, but they can be valuable in some circumstances, such as alerting me to a reason I was unaware of that earnings might depart significantly from recent trends.) As with other metrics, some dividend growth investors adhere to rules about what sort of earnings growth they must see before investing in a company. As I’ve said before, this can be helpful in imposing disciple on an investor, but personally, I prefer to look at the whole story together. Of course I prefer a company with steadily growing earnings, but I will not rule out a company with flat earnings if, say, the payout ratio is low and I believe the company will be able to grow earnings in the future. Also, it is worth noting that earnings can be volatile as a company’s various products fall in and out of favor or as the general economy stalls or thrives.
Intel is a great example of this. If you look at the past five or six years generally, INTC’s earnings growth has been good. But in the past couple of years, it has stalled and is even moving in the wrong direction. Most of the headlines about this suggest that INTC is being hit by the one two punch of missing the boat on chips for mobile devices combined with the death of the PC. A hard and fast rule about a minimum earnings growth rate might exclude INTC as an investment on this basis. But if you believe that INTC is making the right moves to get earnings back on track, this might be an excellent time to get in. On the other hand, if INTC cannot get earnings back on track, their long term ability to continue to raise the dividend at a healthy pace might be compromised.
Whether or not you apply a hard and fast rule about earnings growth, earnings are the lifeblood of the company and the source of the dividends, and so must be monitored very closely.
In the next installment of this series, I’ll discuss the P/E ratio and valuation generally.