In using lists and screens to find dividend stocks, be careful that you do not accidentally concentrate on a specific industry; you must be particularly careful using this strategy, since utilities and, to a lesser extent, financial companies will tend to dominate many of the lists. Since the approach works best with companies paying meaningful dividends, look for dividend yields of at least 2% or more. In addition, you should decide if you want to concentrate on absolute yield (is the dividend yield high compared to all other companies?), relative yield (is it low relative to its industry or to its historical average?), or perhaps both. This will help narrow the selection. Other conditions can help narrow the selection further—for instance, a high risk ranking or rating by one of the information sources.
Once a list of candidates is established, the next step is to perform an in-depth evaluation of the stocks on the list to determine the fair market value.
Pharmaceuticals Inc.: An Example
Pharmaceuticals Inc. offers a good example of the dividend-yield approach, with an above-average dividend yield of 5.7%.
At one time, Pharmaceuticals Inc. represented a fallen angel—a former growth company that had moved into a more mature, slower growth stage. It had popped up on the lists of high-yielding stocks because of concerns over both the industry and company. At that time, in comparison to the overall stock market, drug stocks had been weak performers. Uncertainty surrounding changes to our nation's healthcare and its impact on the traditional drug manufacturers had led to devaluation of drug stocks even though the short-term profit picture had not changed. In the long term, Value Line noted that the industry, long regarded as a growth vehicle, could in a "worst-case scenario" go the way of regulated utilities.
Individual company concerns for Pharmaceuticals Inc. included costs associated with settling cases dealing with silicone breast implants, fewer tax credits for manufacturing operations in Puerto Rico, as well as the normal drug firm concerns involving the loss of patent protection for drug products.
Figure 1 shows the completed worksheet. Value Line was used as the source of both company and industry information. Entering the per share data from a source such as Value Line or S&P is a fairly straightforward process. Numbers are entered into the worksheet from left to right, with the Year 1 column containing the oldest data and Year 5 the most recent. The difficulty lies in determining the type of adjustments the data services made to provide the information. Value Line does not include non-recurring items in its data. For Year 5, Pharmaceuticals Inc. had a $0.60 per share special charge, but this is only footnoted in the $4.40 earnings per share figure it reports for Year 5. Using the reduced $3.80 figure in the valuation worksheet would change the high and low price-earnings ratios for the year, the average price-earnings ratios, the earnings per share growth rate, payout ratio, return on equity, and, ultimately, the valuation. Once you select a source for company information, it is important to stick with it for all of the data elements, unless you know how to adjust the figures to make everything comparable.
Many analysts like to use dividends to value a company because of the purity of the dividend. The reported dividend paid is exactly what was paid, while management has some latitude in reported earnings figures. They may use liberal accounting principles to report higher earnings or decide to defer or take special charges to earnings until it works to their advantage.
A Tour Through the Worksheet: Per Share Information
The first item that should strike you as you look at the price information is the change in trend that occurred between Year 4 and Year 5. Pharmaceuticals Inc.'s price peaked at just over $90 in early Year 4, compared to a mid-Year 6 price of $51.50. This change coincides with weakness in the drug industry.
Next, it is important to examine the year-by-year dividend and earnings per share figures. Even though we are focusing on dividends, it is the profitability and cash generation of the firm that supports the dividend. First, examine the year-by-year figures—are they increasing, decreasing, or holding steady? Has there been a change in trend? Steady, increasing figures are best. Using the Value Line data, we see that earnings, dividends, and book value have increased every year. The five-year average growth rates for earnings and dividends have been 12.5% and 9.5%, respectively. These are strong growth rates, but both earnings and dividends show some slowdown in their growth rates in the later years. Calculating the year-by-year percentage change for earnings and dividends is an effective tool for identifying changes in trends and growth rates.
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