(Note: This Lesson was revised on October 31, 2017. The principal revision is in Section 13, reflecting a change from using Debt/Equity as a measure of leverage to using Debt/Capital.)
Ever since I began investing many years ago, I have graded and ranked stocks.
1. There is no perfect stock. When you examine the details of individual companies, different metrics tell different stories. Sometimes the stories conflict. One metric will be very positive (like a high yield), but another will be negative (the company is buried in debt). Grading helps you pull together a unified view from conflicting information.
2. Avoid overlooking anything. I grade a variety of metrics about every company. The grading system doubles as a checklist of what to look at. Following each step insures that you won’t skip anything important.
3. Weigh different factors against each other. How important is yield compared to the company’s debt load? Reasonable minds can differ, and people with different goals can differ too. Grading allows you to assign each factor the weight that you think is important.
4. 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 that early, you can drop the stock and save a lot of work.
I have experimented with a lot of systems over the years. What I present here is a basic grading system for dividend growth stocks. Many of the elements are identical to the ones that I used to select stocks for my Dividend Growth “ETF.”
You will note that I count a few of the factors double, or utilize them as screens as mentioned earlier. Those reflect value judgements on my part. Your judgements may differ. So remember that you can change anything to suit your own goals and beliefs about what is most important in a company that you are considering owning. There is no universally approved grading system. Add or drop factors. Change weights. Customize it however you wish.
The grading is divided into 4 parts:
• Dividend resume
• Company quality
• Company finances
I usually overweight yield and also use it as a screening factor. In other words, it can eliminate a stock all by itself if the yield is too low.
As you can see, the cutoff for minimum acceptable yield in this chart is 1.0%. That’s what I used in constructing the “ETF.” In my own personal investing, I require stocks to have minimum yields of 2.8%. That’s an example of how you can adjust the values in these charts to suit yourself.
2. Years of Consecutive Increases
I require a minimum of 5 straight years of increases. (See Dividend Growth Investing Lesson 3: The 5-Year Rule.) I also downgrade a stock that just started raising its dividend after the Great Recession that ended in 2009.
3. Dividend Growth Rate
Dividend growth rates (DGR) are important, especially for stocks that start out with low yields to begin with. So I double the points and use DGR as a screen. I generally use the 5-year DGR as the base rate to examine.
In my Dividend Growth Stock of the Month (DGSM) articles, I score DGRs over multiple time frames: The current year, last year, and the last 5 years. That triple coverage provides overweighting on its own.
4. 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 DGR. Every shorter interval has a smaller DGR.
For example, a stock that is new in its dividend growth life often has a declining pattern.
The first dividend (which is an increase from zero) is actually a DGR of infinity.
Then maybe there’s a 50% increase followed by a 30% increase, and so on as the company finds its footing as a new dividend growth stock.
I would not penalize such a company. It may be a gem in the making.
Also, some high-yield stocks have reached a stage of maturity that they just raise their dividend the same dollar amount each year. Obviously this causes the percentage rate of increase to decline a tiny bit each year.
An example would be AT&T (T).
[Source: Dividend Champions spreadsheet]
AT&T has been increasing its dividend by $0.04 per share per year since 2009. As the base amount builds, this means that the percentage increase declines each year. Since 2009, AT&T’s annual percentage increase has declined from 2.5% to 2.1% in 2016.
But AT&T’s yield is large at about 4.6%. So I would not penalize it for tiny increases or the declining percentage rate each year.
5. Dividend Safety Grades
I consult Simply Safe Dividends for these grades. I overweight this factor and also use it as a screen.
These are Simply Safe Dividend’s scoring ranges.
I convert that system to my own scoring like this:
The next group of factors considers the quality of the company. Obviously we want to invest in excellent companies and eliminate companies with difficult problems.
6. 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-. I require all qualifying stocks to be investment grade. This display from S&P defines their grades. As you can see, grades of BB and below are not investment grade.
I use the credit rating as a quality screen. I don’t want to invest in non-investment-grade companies.
This is another quality indicator. A moat is a sustainable competitive advantage. Morningstar assigns moat ratings based on their analysis of the company’s core business.
8. S&P Global Market Intelligence Quality Ratings (revised November, 2017)
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.
9. Company “Story”
The Story is a paragraph about the company as an investment proposition. You write it out to make sure you understand it.
What does the company do? How does it make money? 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 things are:
• legal monopolies
• companies not hindered by regulation (or actually assisted by it, like utilities)
• coherent strategies and growth plans that sound sensible to you
• great brands
• records of innovation and adaptability
• production efficiencies or cost-savings 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 exercise probably sounds tedious, but it will help to 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 can’t understand it, don’t invest in it.
Obviously, the Story is somewhat subjective. Someone else may understand a company’s business model that I just don’t get or trust. That’s OK. I like to stay near my areas of competence.
I score companies on a 15-point scale. I require at least 8 points.
The third group of factors delves into the company’s financial situation. We prefer companies that are profitable, growing, efficient, and have strong balance sheets.
10. 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.
ROE can be artificially inflated if a company carries lots of debt. We will take care of that later by downgrading companies with high debt loads.
11. Earnings Growth and Trends
There are 2 basic ways to measure money flowing through a company: Earnings and cash.
Both begin, of course, with revenue from customers. Earnings and cash are both important, so let’s take a moment to explain the difference.
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 expressing the value of brands, expertise, and other intangibles that the acquiring company receives. GAAP requires that the extra amount paid must be accounted for.
• GAAP requires accountants to shift the timing of cash flows. Cash inflows and outflows are not 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).
Analysts project EPS (earnings per share) growth, typically over the next 3-5 years. Averages are collected and published. To score them, I use the same scale as used earlier for DGR, because all else equal, a mature company will probably grow its dividend at about the same rate that its profits are growing.
I also look at the company’s recent (5-10 years) earnings growth trends. Accelerating growth is great, steady growth is good, and uneven growth (with some negative years) is probably OK. Unrelenting decline is not OK.
12. Cashflow Trend
Cash for a company is like gasoline for a car. It keeps it running. Cash is used to pay salaries, bills, and dividends. There has to be enough cash flowing on a real-time basis to keep the company operating.
Remember that with earnings, cash is sometimes time-shifted. 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.
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.) I find a graph or chart of the company’s cashflow and make a subjective assessment.
13. Debt/Capital (revised November, 2017)
I used to use Debt/Equity to assess a company’s dependence on debt, but I switched to Debt/Capital (D/C) in 2017 because it is a more widely available number.
A company’s D/C ratio measures a company’s financial leverage: How much do they depend on borrowed money to finance their activities? Most companies are not self-funding. They borrow money routinely, financing their operations through a mixture of debt and equity.
Even companies that could be self-funding often borrow money instead. The reasoning is that they can make more money on the borrowed money than borrowing costs in principal and interest payments.
While leverage can help a company grow faster (that’s why it’s called leverage), too much debt can weaken a company or even make its financial structure untenable. The D/C ratio allows us 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, consisting of borrowed money plus shareholder’s equity (money put into the company by investors).
The D/C ratio examines how big a percentage of the mixture of debt and equity 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 huge company. Using the D/C ratio conveys a useful picture of a company’s capital structure no matter what its size.
All else equal, the higher the D/C ratio, the riskier the company is. Debt must be paid back, so debt creates a constant draw on the company’s cash.
Debt repayments stand ahead of dividends in the hierarchy of every company’s obligations.
The formula for D/C is:
D/C = Debt / Total Capital
= Debt / (Shareholders’ Equity + Debt)
My belief is that a reasonable amount of debt can be a good thing. But too much debt can strangle a company. When debt payments come due, the cash must be available. Those required payments may force the company to forgo discretionary activities that might help it grow, but that cannot be pursued because of lack of cash.
Also, 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. The scoring system places that value in the middle, then awards more points for lower debt ratios and fewer points for higher debt ratios.
Finally, we look at a few things that don’t fall neatly into the earlier categories.
Beta measures a stock’s price volatility vs. the S&P 500’s volatility. 1.0 is defined as equal volatility. 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. There is also research that suggests that low-volatility stocks produce higher total returns.
15. Share Count Trend
Some companies buy back their own shares regularly, while others don’t. Some companies issue shares regularly. Some of them have to, because that is the only way to finance their own growth.
All else equal, a declining share count is preferable. I make an assessment of the share count trend over the past 5-10 years. I score it along the following lines.
16. Analysts’ Recommendations
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 own stock reports. They normalize the different systems used by various analysts into a scale of 1-5, where 1 = strong sell, 3 = hold, and 5 = strong buy.
As I said at the beginning, this is a basic system. You can change 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.
Whether you add up the points is up to you. I often don’t. I simply create summaries using the colors. 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 a nightmare to own.
The above scoring system was 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.
Dave Van Knapp