A stock with a high yield doesn’t mean much if the dividend is cut or eliminated, and the stock price declines significantly. Sometimes it is desirable to accept higher risk for a higher yield. Other times we may be accepting higher risk and are not being adequately compensated for the additional risk. What can we do to help gauge the risk of an individual stock?
In my dividend database I track over 180 stocks, with each having a minimum of 10 years of historical information. This data is gathered from various sources deemed reliable. Most data is generic and can be pulled from various internet sites. I then combine this information into metrics that I consider relevant in determining the stocks ability to sustain and grow its dividend.
Risk is one of the key factors I look at. Risk can have as many definitions as the number of people you ask to define it. Ultimately, we are trying to access how likely is it that something bad will or will not happen. As a quantitative first pass, I consider the following factors:
Dividend Increase Risk (R)
One important metric in accessing the likelihood of future dividend increases is past performance. The logic here is the longer a company raises its divided, the more committed it is to dividend increases and is less likely to stop unless dire financial circumstances dictate it. I use the following criteria to assign the A, B or C risk rating:
- A is assigned to companies that have increased their dividends for more than 25 years (numeric value of 1).
- B is assigned to companies that have increased their dividends for 15-25 years (numeric value of 2).
- C is assigned to companies that have increased their dividends for less than 15 years (numeric value of 3).
Quality of Dividend Increases (Q)
In determining the quality of the dividend, I look at the company’s financial quality by focusing on Free Cash Flow payout and Debt to Total Capital. I assign a 1, 2 or 3 Quality Rating based on:
- 1 is assigned to companies if their Free Cash Flow Payout % is less than 60% and if their Debt to Total Capital is less than 45%.
- 2 is assigned to companies if the sum of their Free Cash Flow Payout % plus their Debt to Total Capital is less than 100%.
- 3 is assigned to companies if the sum of their Free Cash Flow Payout % plus their Debt to Total Capital is greater than 100%.
Current Price vs. Calculated Price (P)
As part of my quantitative analysis, I calculate a “Buy Below” price. If the current price is within plus or minus 10% of the calculated price then this portion of the calculation is assigned a value of 1 (low risk). Results between plus or minus 10% but less than 20% is assigned a value 2 (medium risk), while anything plus or minus 20% or greater is assigned a 3 (high risk).
Dividend Yield (Y)
Dividend yield is an indication of market sediment, and often an early warning for a troubled stock. In this portion of the calculation, the current yield is compared to predetermined levels and a risk value is assigned. Currently, I am assigning a 1 (low risk) to yields less than 5%, a 2 (medium risk) to values from 5% to less than 8% and a 3 (high risk) for values 8% and greater. The predetermined levels are purely arbitrary and subject to future calibration.
Some might argue that it is “normal” for certain industries to pay out a higher yield, such as 10%. However, I think that “normal” higher yield could be indicative of the implicit higher risk of that industry. Blue water shipping (ocean going) would be an example of this. Also, certain industries, such as utilities, tend to sustain a higher yield due to their lack of growth opportunities.
Putting It All Together
My Risk Rating is calculated by averaging the four numeric values above, as such:
(R + Q +P +Y)/4 = Risk Rating
This calculation will yield values between 1 and 3. I divided this range into thirds and assigned an overall rating based on this table:
- 1.00 to less than 1.67 = Low Risk
- 1.67 to less than 2.34 = Medium Risk
- 2.34 to 3.00 = High Risk
Based on calculations from this past weekend, below are ten stocks with a low risk rating:
|ADP, Inc. (ADP)||-||1.00||3.29%|
|Chubb Corp. (CB)||-||1.00||2.82%|
|Medtronic, Inc. (MDT)||-||1.00||2.42%|
|AT&T Inc. (T)||Link||1.25||6.76%|
|Genuine Parts (GPC)||Link||1.25||4.03%|
|Clorox Co. (CLX)||-||1.25||3.30%|
|Pepsico, Inc. (PEP)||-||1.25||3.10%|
There are other factors that can affect the risk of an individual stock such as industry, geopolitical factors, technology, et. al. Needless to say, all these must be considered as we make our decision to buy or sell a stock.
Full Disclosure: Long JNJ, PEP, PG, UTX, WMT. See a list of all my income holdings here.
(Photo: sean carpenter)