Important Note from Dividends & Income: For dividend growth investors, the following lesson from Dave Van Knapp could be the most important information we publish this year. In short, it lays out the key steps you should take when deciding what stocks to buy and when to buy them. Our suggestion is to print out this lesson, keep it close by, and review it before you buy your next stock.
Why Grade Stocks?
When I am selecting stocks to invest in, I grade them.
Here’s why.
- There is no perfect stock. When you examine the details of individual companies, different pieces of information tell different stories. Sometimes the stories conflict. One metric will be positive (like a high yield), but another will be negative (the dividend is at risk). Grading helps pull together a unified view about the company’s prospects.
- Avoid overlooking anything. I grade a variety of metrics about every company. The system acts as a checklist of what to look at. Following each step insures that you won’t overlook anything important.
- Save work. Some of the grading factors act as screens. For example, for me a stock with a lousy dividend safety grade is not a candidate for purchase. If you spot a disqualifying factor early, you can drop further research and save a lot of work.
I have experimented with a lot of systems over the years. What I present here is a distillation of what I have learned about scoring dividend growth stocks. Consider it as a basic system to start with, one that you can adjust and improve as you learn about stocks.
In your own work, you may want to weigh some factors more heavily than others. You will also certainly want to apply the scoring factors differently when you encounter special situations.
So use your judgement. Add or drop factors. Change weights. Customize it however you wish. But at a minimum, I would suggest that you use it as a checklist of things to look at when you are considering a stock.
I use a “stoplight” system for issuing grades: Green means go (good), yellow means caution, and red means stop (bad). The colors alone provide a great visual for the potential investor. If there’s lots of green, you’re probably looking at an excellent company. If you’re seeing lots of orange and red, it might be one you want to skip.
One thing I have observed over the years is that whatever the details of the system you use, the cream always rises to the top. The best companies emerge, and weaker companies sink.
The grading system has 18 factors divided into 4 categories:
1. Dividend resume
2. Company quality
3. Company finances
4. Miscellaneous
Category 1: Dividend Resume
- Yield
I use yield as a screening factor as well as a metric to be graded. In other words, it can eliminate a stock all by itself if the yield is too low.
- Years of Consecutive Increases
In order for a stock to be recognized as a “dividend growth stock,” I require a minimum of 5 straight years of increases (see Dividend Growth Investing Lesson 3: The 5-Year Rule). If a company is just initiating a dividend, that first year counts as Year 1 of the increase streak.
All qualifying stocks can be found on the Dividend Champions, Contenders, and Challengers (CCC) document available here on Dividends & Income.
- Dividend Growth Rate
I judge dividend growth rates (DGR) in relation to the stock’s yield.
A stock with a high yield – for example >4% – does not need as fast a growth rate to be valuable as a stock with a low yield.
The following chart divides stocks into 3 categories: Low Yield, Medium Yield, and High Yield. Then it suggests grades for various DGRs.
I usually judge DGRs over multiple time frames: current year, last year, and the last 5 years. That triple coverage means that DGR is heavily weighted in my analysis.
- Dividend Growth Trend
I usually don’t like to see a pattern where the DGR has been continually declining: That would look like this: 10-year DGR > 5-year DGR > 3-year DGR > 1-year DGR > this year’s increase. Every shorter interval has a smaller DGR, meaning that the average annual increases are going steadily down. They’re still increases, but getting continually smaller.
There are exceptions.
For example, a stock that is new in its dividend growth life often has a declining pattern. Its first dividend (which is an increase from zero) is actually a DGR of infinity. Then maybe there’s a 30% increase followed by a 20% increase, and so on as the company finds its footing as a new dividend growth stock.
I would not penalize such a company for its declining DGR. It may be a gem in the making. In recent years, we have been seeing this with established tech companies, former high fliers that one-by-one are initiating dividends as they mature.
Here is Microsoft’s (MSFT) record, for example (it paid its first dividend in 2003). Its DGR is slowing down, but that’s no reason to penalize it.
At the other end of the spectrum, some high-yield stocks have reached a stage of maturity that they just raise their dividend the same dollar amount each year, typically a few cents. Mathematically, this causes the percentage rate of increase to decline a tiny bit each year.
An example would be AT&T (T). Since 2009, its annual increase has been 4 cents each year. Obviously, as the base amount rises, the percentage increase is slightly declining every year.
- Dividend Safety
I consult Simply Safe Dividends for these grades. They grade dividend safety on a 0-100 scale.
Category 2: Company Quality
This group of factors considers the quality of the company. Obviously, we want to invest in excellent companies and eliminate companies that are poorly run or are facing difficult problems.
Here are the factors that I use.
- S&P Credit Ratings
S&P’s credit ratings range from AAA (the best) to C (the worst). The ratings can be further nuanced by a plus or a minus (as in A+).
The lowest “investment grade” rating is BBB-. Ratings below that indicate significant speculative characteristics. I require all qualifying stocks to be investment grade.
This display from S&P defines how they grade companies. Investment grade issuers are in the top 4 lines, from AAA to BBB.
I convert S&P’s credit ratings to my own scoring like this:
- Moat
A company has a moat when it has sustainable competitive advantages.
Morningstar assigns moat ratings based on their analysis of how long a company’s competitive advantages can last. Here’s how they assign rankings:
A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat.
- S&P Global Market Intelligence Quality Ratings
S&P is one of many information providers that grade companies on various factors. I like to use their ratings, because (like Morningstar) they are independent information providers, not “sell-side” analysts.
Their Quality ratings are now known as S&P Global Market Intelligence’s Quality Rankings (formerly they were called S&P Capital IQ Quality Ratings). They appear in CFRA stock reports, which are available from many brokerages.
Here is how they describe their rankings:
- Value Line Safety Rank
If you have access to Value Line (many libraries do), they have a Safety rank that implies company quality. It looks like this on their stock research pages:
[The Safety rank] measures the total risk of a stock relative to the [other stocks that Value Line covers]…. Safety ranks are…given on a scale from 1 (Highest) to 5 (Lowest) as follows:
-Rank 1 (Highest): These stocks, as a group, are the safest, most stable, and least risky investments relative to the Value Line universe.
-Rank 2 (Above Average): These stocks, as a group, are safer and less risky than most.
-Rank 3 (Average): These stocks, as a group, are of average risk and safety.
-Rank 4 (Below Average): These stocks, as a group, are riskier and less safe than most.
-Rank 5 (Lowest): These stocks, as a group, are the riskiest and least safe.Stocks with high Safety ranks are often associated with large, financially sound companies; these same companies also often have somewhat less-than-average growth prospects because their primary markets tend to be growing slowly or not at all. Stocks with low Safety ranks are often associated with companies that are smaller and/or have weaker-than-average finances; on the other hand, these smaller companies sometimes have above-average growth prospects because they start with a lower revenue and earnings base.
I convert Value Line’s Safety rank to my own grades as follows:
- Company Business Model – What’s the “Story”?
The Story is a few paragraphs about the company as a business.
I write it out to make sure I understand it. If I can’t understand in general how a company makes money, I won’t invest in it.
As the famous investor Peter Lynch said:
If you’re prepared to invest in a company, then you ought to be able to explain why in simple language that a fifth grader could understand, and quickly enough so the fifth grader won’t get bored. [Source]
That simple explanation is often called the stock’s Story. The Story answers questions like these:
- What does the company do?
- How does it make money?
- Does it have coherent strategies to protect its earnings and to grow them?
- Why is it likely to continue to succeed?
Look for companies that are dominant in their fields. If a company is riding a long-term mega-trend (demographic, technological, etc.), that’s a plus.
Other good signs are:
- legal monopoly
- company not hindered by regulation (or actually assisted by it, like utilities)
- coherent strategies and growth plans that sound sensible to you
- great brands
- record of innovation and adaptability to changing conditions
- production efficiencies or cost-saving programs
- timeless and everyday products and services that people need
- sustainable competitive advantages (moats)
- proven shareholder orientation
We want companies that are relatively immune from technological disruptions, product obsolescence, or shifting tastes, fads, and fashions. Whether any company can retain industry leadership is impossible to know, but you want to find evidence to help you answer that question.
Explain the company’s Story to yourself in simple language. Be crystal clear in describing what the company does, how it makes money, and why you think its business is sustainable. This is no time to delude yourself.
This exercise may sound tedious, but it will help steer you away from unsound companies. If you find yourself with seeds of doubt when trying to write the company’s Story, that may be a clue that the company really isn’t very good or that you don’t understand it. Don’t force it.
If you don’t understand it, don’t invest in it.
Obviously, the Story is somewhat subjective. Someone else may understand a company’s business model that you just don’t get or trust. Stay near your areas of competence and be comfortable with the companies that you own.
I score company Stories on this scale:
The third group of factors delves into the company’s financial situation. I want to find companies that are profitable, growing, efficient, and have strong balance sheets.
Again, if you have access to Value Line, they have a Financial Strength Grade rating that summarizes and scores a company’s overall financial situation, such as this:
In the Company Financials category, I do not use failing (red) grades as screens, because I want to get a total picture based on the variety of metrics that I use. All of the metrics are easy to find on standard financial websites such as Morningstar.
Here they are.
- Return on Equity (ROE)
Return on Equity is a standard measure of efficiency in a company. It indicates how much return a company is generating per dollar invested in it.
The average ROE among Dividend Champions is 16%, and for S&P 500 companies it is about 13%. I score the company’s trailing 12-month ROE as follows.
ROEs often vary from year to year. Therefore, in addition to the current ROE, I also look at the company’s ROEs over the past 10 years to look for consistency. I score the record as follows:
- Debt to Capital (D/C)
A company’s Debt-to-Capital ratio measures its financial leverage: How much do they depend on borrowed money to finance their activities?
Most companies carry debt. They borrow money routinely, financing their operations through a mixture of debt, equity (money invested by shareholders), and their own cash flows.
Even companies that could be self-funding often borrow money instead. The reason is that they can make more money on the borrowed money than the borrowing costs. That’s called leverage.
That said, debt repayment obligations are a constant drain on a company’s resources. While leverage can help a company grow faster, too much debt can weaken a company or even make its financial structure untenable.
The D/C ratio gives insight into whether a company is depending on debt too much. It compares the company’s debt to its total capital. Total capital, in turn, is all the capital the company has.
The D/C ratio shows what percentage of a company’s total capital structure is debt. A ratio is used, rather than the dollar amount of debt, to allow us to compare companies of different size. $10,000,000 in debt might cripple a small company but be only a rounding error for a large company.
All else equal, the higher the D/C ratio, the riskier the company is. Companies that are highly dependent on debt to fund themselves are more likely to have trouble when business conditions weaken or a recession strikes.
A high debt load can give a company an artificially high ROE number. We credited high ROEs earlier. So if the company is achieving a high ROE via high debt, we penalize it here for the high debt to balance things out.
In the low-interest-rate world of the past few years, many companies have taken on more debt because it has been so cheap to do so. Average D/C ratios are often in the 50% range, meaning that half the company’s total capital is debt.
Here’s how I score debt.
- Operating Margin
Operating margin is a measure of profitability. It measures what percentage of revenue is turned into profit after subtracting cost of goods sold and operating expenses.
Per a report from Yardeni Research published in 2018, the operating margin across S&P 500 companies is around 11%-12%, as shown in the following graph.
There are 2 basic ways to measure the money flowing through a company: Earnings and cash. Both begin, of course, with revenue from customers, which then goes through the company’s financial “machine” to produce earnings and cash.
Earnings are the officially reported profits calculated according to Generally Accepted Accounting Principles (GAAP). There are a couple of important points to remember about GAAP.
- GAAP occasionally counts as “money” things that are not cash. A simple example is goodwill. If an acquiring company pays more than book value for an acquired company, the difference is called goodwill. That is a way of monetizing the brands, expertise, and other intangibles that the acquiring company receives, even though the intangibles have no cash value.
- GAAP requires accountants to shift the timing of cash flows. Cash inflows and outflows are not always recognized at the time of actual receipt and disbursement, but rather when the events associated with the cash take place. An example would be a subscription business that takes in cash when subscriptions are paid for, but counts them as revenue only when content is sent to the subscriber. Another example would be when a company pays for equipment with cash, but GAAP requires the cost to be depreciated over the useful life of the equipment (several years).
I look for earnings per share (EPS) that have been consistently positive, with extra points for a general pattern of growth.
Cash for a company is like gasoline for a car. It keeps it running. Cash is used to cut checks for salaries, bills, debts, and dividends. There has to be enough cash flowing on a real-time basis to keep the company operating.
Remember that with earnings, money is sometimes time-shifted under GAAP rules. Cashflow is not time-shifted. If the payroll is due this Thursday, the company must have the cash to cut the checks on Thursday. If the dividend is to be paid next week, the cash must be ready on the payable date. Debt payments must be made on time.
As investors, we want companies that are not only profitable under GAAP but also have strong cash flow. I will omit the gory details, but a company can be GAAP-profitable but strapped for cash. And vice-versa: A company can have sufficient cash to run itself but be unprofitable under GAAP rules.
There are various flavors of cash flow. I use free cash flow (FCF), which is what is left after a company has paid all of its bills and reinvested to maintain and grow its business.
I find a graph or chart of the company’s FCF and make an assessment.
Finally, we look at a few things that don’t fall neatly into the earlier categories.
- Beta
Beta measures a stock’s price volatility vs. the S&P 500’s volatility. 1.0 is defined as the stock being equal to the index. So if a stock has a beta of 0.7, its price tends to move only 70% as much as the market, on average.
Generally, I prefer lower-volatility stocks, because they tend to give you fewer reasons to worry about price swings. Not only that, but there is also research that suggests that low-volatility stocks produce higher total returns over the long haul.
- Share Count Trend
Some companies buy back their own shares regularly. They may retire the shares, and when they do, it makes each remaining share more valuable. They are able to do this because they have money left over every year after paying all their bills and dividends.
You cannot assume that because a company buys back shares that it will retire them. Some repurchased shares aren’t retired at all: They are used to pay executive compensation. So beware of companies that equate buying back shares with “returning money to shareholders.” I consider that to be disingenuous. The only value to shareholders comes if the company retires the shares.
At the other end of the spectrum, many companies issue shares regularly. Issuing new shares or debt to raise capital may be the only way to finance growth initiatives. Real estate investment trusts (REITs), for example, must by law pay out most of their profits to shareholders as distributions. They can’t use that money to help finance growth. Thus they must issue more shares and/or borrow money to fund their growth.
All else equal, a declining share count is preferable. For one thing, it means that the annual dividend pool is spread over fewer shares, so it’s easier for the company to pay and raise its dividend per share as the number of shares shrinks.
I assess the share count trend over the past 10 years and score it along the following lines.
Sell-side analysts constantly issue stock reports and recommendations. Some information providers poll analysts and report their average recommendations.
I use the summaries that CFRA (formerly S&P Capital IQ) puts into their stock reports. They normalize the different systems used by various analysts into a standard scale of 1-5, where 1 = strong sell, 3 = hold, and 5 = strong buy.
The above scoring system is about evaluating the excellence of a company as a business.
Even a great business, though, may not be a great investment if its stock is overvalued. A company may be the best in its field, but if its stock is overvalued, it may not be a good investment proposition at its current price.
So I check valuations separately. Valuing stocks is easy. I laid out my system in Dividend Growth Investing Lesson 11: Valuation. When you are making investment decisions, I suggest that you rate both the excellence of the company and the valuation of its stock.
Key Takeaways from this Lesson
- The myriad quality and financial aspects of a company can be sorted into a logical, step-by-step grading system.
- Divide the grading components into bite-size chunks:
- Dividend record and outlook
- “Story” – how does the company make money, and why is it likely to continue to be successful?
- Financials, with focus on profitability, earnings, cashflow, and debt
- Pull everything together into a coherent thesis on why the company is a good one or not for the type of portfolio you want.
- Consider valuation separately. A great company may not be priced well enough to buy.
Dave Van Knapp
Click here for Lesson 15: Portfolio Management – How to Decide When to Sell Stocks
This lesson was updated 10/10/2018
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