Dividend yield is an oddity because the yield increases as the stock price falls. So you could be getting an ever-growing percentage of an ever-shrinking pot. Think back to 2008, for example. When prices of many stocks declined broadly, what happened to a stock falling by $5 a month and paying an annual dividend of $1 per share? As the price fell, the yield rose (see table, below).
In this case, the dividend yield doubled over six months. Good news by itself, but over the same period you lost half your value per share in the stock. This is one of the many reasons investors discount dividend yield as an indicator; it doesn’t reflect the relationship between fundamental value and current price. Whenever the market’s technical side is down — from late 2008 through early 2009, for example — yield is going to be misleading. If a company’s stock price has fallen because of inherent weakness of the company, its sector or the larger economy, the yield isn’t as sound a fundamental indicator as other tried-and-true metrics, such as revenue and earnings trends and the current, debt and price-earnings ratios.Making Dividends a Reliable Indicator
But there’s another way to analyze dividends to identify exceptional opportunities, even in depressed markets. This requires analyzing dividends as part of a long-term trend and in conjunction with other key indicators. This not only improves the accuracy of the review but also helps narrow the list of viable investment candidates.
As of late April 2009, for example, it was quite difficult to select high-quality stocks based on the traditional analysis of revenue and earnings. So many companies — more than usual by most standards — were available at bargain prices, but were all of these exceptional long-term, buy-and-hold investments? A study of revenues and net earnings doesn’t reveal the distinctions between two types of companies: those most likely to bounce back once the recession ends and those suffering long-term degeneration in value.
Unfortunately, many firms honored in the past as safe and sound blue chips haven’t always endured. For example, General Motors and Eastman Kodak, two of the shining stars of the 20th century, have today become low-value, high-risk has-been investments.
They’re hardly alone. A few years ago, the financial sector was considered among the safest and most promising of long-term investment sectors. Companies such as Washington Mutual, Citigroup and Bank of America were held in high esteem. Today, however, the financial sector is in very poor shape and many companies — including Citigroup — will probably never recover fully.
We need to carefully quantify the popular belief that after prices fall, smart investors should gobble up bargain-priced companies. Investors look for companies that combine demonstrated long-term growth and prospects for stock price appreciation. But revenues and net earnings don’t tell the whole story after a down year. For example, consider these three well-known companies: Johnson & Johnson (ticker: JNJ), Coca-Cola (KO) and General Electric (GE). Which of these hold promise for growth in coming months, and which aren’t as likely to recover? (Companies are mentioned in this article for educational purposes only. No investment recommendation is intended.)
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Let’s begin by comparing 10 years of results for three popular indicators: revenues, net income and dividends per share (see tables, above).
A glance at only the revenues and net income seems to place all three companies on the same footing. All have shown a decade of growth, the only major slip being GE’s net income decline in 2008. But the differences are more significant when you compare dividend history. Over the past decade, both Johnson & Johnson and Coca-Cola increased their dividend every year without fail. GE reduced its 2008 dividend for the first time in 10 years.
By itself, the dividend history doesn’t condemn GE. But when viewed with other important indicators, an investor likely will conclude that GE is the least promising of these three companies. For example, the price range for General Electric in 2008 was from $38 down to $12 per share, a drop of 68 percent. (In comparison, Johnson & Johnson ranged between $72 and $52, a 28 percent difference, and Coca-Cola ranged from $65 down to $40, a change of 38 percent.)
Another important difference is found in the debt ratio, the portion of total capitalization represented by long-term debt. Although Johnson & Johnson (15.6 percent) and Coca-Cola (11.5 percent) have kept long-term debt at the same level for the decade, GE’s has increased to 74 percent (not unusual for a company with a financial services arm) from 55 percent 10 years ago.Click image to enlarge
Dividend Achiever Status as a Primary Test
Dividend yield is virtually useless as a trend indicator, especially compared with the more meaningful revenue, net profit and debt ratio changes over time. But companies that have increased their dividend every year for at least 10 years — the so-called dividend achievers — tend to be better-managed companies with lower-than-average price volatility, little or no core earnings adjustments and more capability to weather recessionary times. By definition, a company able to increase its dividends has to be in control of its cash flow.
Mergent Corporation follows dividend achievers and has created an index of companies meeting this criterion. In its most recent report, fewer than 300 companies met this important test. (Standard & Poor’s compiles a separate index called the Dividend Aristocrats.)
Increasing dividends every year without fail is a good test of working capital and quality of management. The dollar value of dividends is relatively small. Johnson & Johnson’s dividend of $180 annually for 100 shares is peanuts. But as a symptom of quality, the dividend achiever
company is exceptional.
Growth in dividends also is important if you reinvest your dividends automatically through a dividend reinvestment plan, or DRIP. When Johnson & Johnson credits your account with dividends, you can let the cash ride or earn about 1 percent in your brokerage cash account, or you can reinvest it in more shares of Johnson & Johnson and get 3.6 percent on the growing share total. Dividend reinvestment is a smart idea, and with dividend achievers, the compound yield goes up every year.
Dividends by themselves are a small piece of the bigger puzzle. But limiting your search to the very small group of companies that have grown their dividends every year helps cut down the list of potential investments. Combined with analysis of revenue, net income, P/E, debt ratio and other key fundamental tests, dividend trends help you decide whether depressed-price companies are never going to come back — or are the most promising candidates for a strong rebound.