1. Declining Shares

Many companies sell stock to raise cash. The important question is what is the company going to do with the cash? Is it for an acquisition or “general corporate purposes?” The latter is code for the business is not generating enough cash to stay afloat on its own. I am wary of a company that consistently has more shares outstanding in the current year when compared to the prior year. As I enter updates to my database, equal or lower shares outstanding is a sign of a healthy business.

2. Declining Debt

When companies need to raise cash and selling shares is not a good option, they often will issue debt. Once again, the important question is what is the company going to do with the cash? Like issuing shares, debt for a strategic acquisition is much more palatable than for “general corporate purposes.” I am wary of a company that consistently has more debt outstanding than the year before. As I enter updates to my database, I make note of companies with a declining debt balance and see that as a sign of a healthy business.

3. Rising Equity

Changes in shareholder’s equity are a result of earnings, dividends paid, treasury stock purchased, stock options exercised and stock issued. If shares outstanding aren’t increasing, and equity is rising then the business is generating sufficient earnings to cover dividends and share repurchases. Increasing the value of the company by running the business well is a sign of a healthy company.

4. Rising Free Cash Flow/Share

Ultimately, we want our investments to generate more free cash flow so they can pay us higher dividends. Free cash flow is an important metric in that it excludes cash generated from issuing stock or issuing debt or selling off parts of the business. Free cash flow is limited to only the cash generated from running the business.

Dividend Stocks Headed In The Right Direction

Combining the equity and debt metrics, I looked for companies with a declining Debt to Total Capital ratio, and combining the free cash flow and shares outstanding metrics, I looked for a rising free cash flow per share. Below are several companies I noted that exhibited each of the above characteristics:

Automatic Data Processing Inc. (ADP) is one of the world’s largest independent computing services companies, providing a broad range of data processing services.
Debt to Total Capital | 2005: 1%, TTM: 1%
Free Cash Flow/Share | 2005: $2.10, TTM: $3.06
Yield: 2.84%

Cullen/Frost Bankers, Inc. (CFR) is one of the largest multi-bank holding company headquartered in Texas, has more than 110 offices in various cities in the state.
Debt to Total Capital | 2005: 30%, TTM: 15%
Free Cash Flow/Share | 2005: $2.13, TTM: $5.23
Yield: 2.98%

Erie Indemnity Co. (ERIE) provides sales, underwriting, and policy issuance services to the policyholders of Erie Insurance Exchange in the United States.
Debt to Total Capital | 2005: 0%, TTM: 0%
Free Cash Flow/Share | 2005: $4.33, TTM: $6.93
Yield: 2.77%

Genuine Parts Co. (GPC) is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products.
Debt to Total Capital | 2005: 16%, TTM: 15%
Free Cash Flow/Share | 2005: $2.03, TTM: $3.57
Yield: 2.97%

Owens & Minor Inc. (OMI) is a leading domestic distributor of medical and surgical supplies to the acute care market, a health care supply chain management company, and a direct-to-consumer (DTC) supplier of testing and monitoring supplies for diabetes.
Debt to Total Capital | 2005: 29%, TTM: 20%
Free Cash Flow/Share | 2005: $1.75, TTM: $3.08
Yield: 2.25%

The Procter & Gamble Company (PG) is a leading consumer products company that markets household and personal care products in more than 180 countries.
Debt to Total Capital | 2005: 38%, TTM: 33%
Free Cash Flow/Share | 2005: $2.65, TTM: $3.46
Yield: 3.00%

RPM International Inc. (RPM) makes specialty coatings and products for the structural waterproofing and corrosion control markets, as well as products for the consumer, do-it-yourself, and hobby markets.
Debt to Total Capital | 2005: 44%, TTM: 43%
Free Cash Flow/Share | 2005: $0.81, TTM: $1.34
Yield: 3.47%

J.M. Smucker Co.’s (SJM) products include coffee, fruit spreads, peanut butter, shortening and oils, ice cream toppings, health and natural foods, and beverages. The Folgers coffee business was acquired in November 2008.
Debt to Total Capital | 2005: 21%, TTM: 19%
Free Cash Flow/Share | 2005: $1.84, TTM: $3.69
Yield: 2.61%

Sonoco Products Co. (SON) makes paper and plastic packaging products serves various industries and markets in more than 85 countries.
Debt to Total Capital | 2005: 38%, TTM: 29%
Free Cash Flow/Share | 2005: $0.98, TTM: $1.68
Yield: 3.10%

Suburban Propane Partners LP (SPH) is a limited partnership that markets propane gas and other refined fuels to residential, commercial, industrial, and agricultural customers.
Debt to Total Capital | 2005: 88%, TTM: 44%
Free Cash Flow/Share | 2005: $0.33, TTM: $3.67
Yield: 5.88%

AT&T Inc. (T) provides telephone and broadband service and holds full ownership of AT&T Mobility (formerly Cingular Wireless). AT&T Corp. was acquired in late 2005 and BellSouth in late 2006.
Debt to Total Capital | 2005: 42%, TTM: 39%
Free Cash Flow/Share | 2005: $2.10, TTM: $2.50
Yield: 5.88%

V.F. Corp. (VFC) is a global apparel company, with leading shares in denim and daypacks. It is transforming itself into a designer and marketer of lifestyle apparel brands.
Debt to Total Capital | 2005: 22%, TTM: 20%
Free Cash Flow/Share | 2005: $4.11, TTM: $9.46
Yield: 2.71%

Verizon Communications Inc. (VZ) offers wireline, wireless and broadband services primarily in the northeastern United States. It acquired MCI Inc in 2006 and has since sold or spun off non-core assets. Alltel was acquired in early 2009.
Debt to Total Capital | 2005: 50%, TTM: 39%
Free Cash Flow/Share | 2005: $2.37, TTM: $6.07
Yield: 5.22%

Businesses can pay dividends with cash generated from many sources. They can generate cash by issuing shares, which dilutes our ownership. They can generate cash by issuing debt, which burdens the company with interest payments. Or, they can generate cash by running the business well, which neither dilutes the current shareholders’ interest or burdens them with future cash payments. Which would you rather have?

Full Disclosure: Long ADP, GPC, OMI, PG, T. See a list of all my income holdings here.

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(Photo Credit)

Dividends Received

Total dividends received during the month were $218.33, consisting of:

• $29.04 The Coca-Cola Company (KO)
• $7.57 Vanguard Intermediate-Term Bond ETF (BIV)
• $11.48 Genuine Parts Company (GPC)
• $14.96 Automatic Data Processing, Inc. (ADP)
• $31.68 Kimberly-Clark Corporation (KMB)
• $27.00 Leggett & Platt, Incorporated (LEG)
• $24.00 Cincinnati Financial Corp. (CINF)
• $38.00 Sysco Corp. (SYY)
• $4.90 PowerShares Emerging Mkt Debt (PCY)
• $29.70 Medtronic, Inc. (MDT)

Dividend Stock Purchases

The following securities were purchased during the month:

• 30 Shares Johnson & Johnson (JNJ) providing $64.80 in annual dividend income
• 50 Shares Harleysville Group Inc. (HGIC) providing $72.00 in annual dividend income
• 58 Shares AT&T, Inc. (T) providing $97.44 in annual dividend income
• 40 Shares Automatic Data Processing, Inc. (ADP) providing $54.44 in annual dividend income

Also, I liquidated my position in Vanguard Intermediate-Term Bond ETF (BIV).

Annualized Dividend Income

Including the above purchases, my annual PCP dividend income is now $2,494.16 at the current dividend rates. This is up $293.84 from last month’s $2,200.32 amount. The PCP has never had a monthly decline in annualized dividend income.

Portfolio Returns

• Month: 2.31%
• Year-to-date: 11.98%
• Life-to-date: 15.30% (annualized)

My PCP holdings are always available by selecting the Holdings option from the menu in the header. The next PCP update will be mid-December.

(Photo: sanja gjenero)

Below are several companies that are providing their shareholders a growing income through higher cash dividends:

Cinemark (CNK) is a motion picture exhibition company that operates in U.S., Canada, Mexico, Argentina, Brazil, Chile, Ecuador, Peru, Honduras, El Salvador, Nicaragua, Costa Rica, Panama and Colombia. November 5th the company increased its quarterly dividend 16.7% to $0.21/share. The dividend is payable on December 7, 2010 to stockholders of record on November 22, 2010. The ex-dividend date is November 18, 2010. The yield based on the new payout is 4.52%.

TELUS (TU) is a Canadian telecommunications company, providing a range of telecommunications products and services. November 5th the company raised its quarterly dividend 5% C$0.525/share. The yield based on the new payout is 4.81%.

Equifax (EFX) is a leading worldwide source of consumer and commercial credit information. November 8th the company increased its quarterly dividend 300% to $0.16/share. The dividend is payable on Dec. 15 to shareholders of record on Nov. 24. The ex-dividend date is Nov. 22. The yield based on the new payout is 1.84%.

Mesa Laboratories (MLAB) designs, manufactures, and markets instruments and disposable products for industrial applications and healthcare. November 8th the company raised its quarterly dividend 9.1% to $0.12/share. The dividend is payable December 15, 2010, to shareholders of record on November 29, 2010. The ex-dividend date is November 25, 2010. The yield based on the new payout is 1.88%.

Baxter Int’l (BAX) is a global medical products and services company provides critical therapies for people with life-threatening conditions. November 9th the company increased its quarterly dividend 7% to $0.31/share. The dividend is payable on January 5, 2011, to shareholders of record as of the close of business on December 10, 2010. The ex-dividend date is December 8, 2010. The yield based on the new payout is 2.40%.

Estée Lauder (EL) is one of the world’s leading manufacturers and marketers of skin care, makeup and fragrance products. November 9th the company raised its annual dividend 36% to $0.75/share. The dividend is payable on December 15, 2010 to stockholders of record at the close of business on November 29, 2010. The ex-dividend date is November 25, 2010. The yield based on the new payout is 1.06%.

Automatic Data Processing (ADP) is one of the world’s largest independent computing services companies and provides a broad range of data processing services. November 9th the company increased its quarterly dividend 6% to $0.36/share. The dividend is payable on January 1, 2011 to shareholders of record at December 10, 2010. The ex-dividend date is December 8, 2010. ADP is a Dividend Aristocrat and has raised its dividend for 35 consecutive years. The yield based on the new payout is 3.2%.

Timken (TKR) manufactures anti-friction bearings and assemblies, alloy steels and aerospace power transmission systems and provides related products and services. November 9th the company raised its quarterly dividend 38% to $0.18/share. The dividend is payable on December 2, 2010, to shareholders of record as of November 22, 2010. The ex-dividend date is November 18, 2010. The yield based on the new payout is 1.67%.

Prudential Financial (PRU) provides a wide range of insurance, investment management and other financial products and services to customers in the U.S. and overseas. November 9th the company increased its annual dividend 64% to $1.15/share. The dividend is payable on December 17, 2010, to shareholders of record at the close of business on November 23, 2010. The ex-dividend date is November 19, 2010. The yield based on the new payout is 2.10%.

Tennant (TNC) designs, manufactures, and markets cleaning solutions. November 9th the company raised its quarterly dividend 21% to $0.17/share. The dividend is payable on Dec. 15 to shareholders of record on Nov. 30. The ex-dividend date is Nov. 26. TNC is a Dividend Achiever and has raised its dividend for 36 consecutive years. The yield based on the new payout is 1.94%.

Equity LifeStyle Props (ELS) trust owns and operates manufactured housing communities throughout the U.S. November 9th the company increased its annual dividend 25% to $1.50 for 2011. Yield on the 2011 dividend is 2.58%.

AmerisourceBergen (ABC) is a distributor of pharmaceutical products and related health care services and was formed via the August 2001 merger of Amerisource Health Corp. and Bergen Brunswig Corp. November 11th the company raised its quarterly dividend 25% to $0.10/share. The dividend is payable December 6, 2010, to stockholders of record at the close of business on November 22, 2010. The ex-dividend date is November 18, 2010. The yield based on the new payout is 1.27%.

MDU Resources (MDU) is involved in electric and natural gas distribution, natural gas storage, gathering and transmission, construction materials and mining, and oil and natural gas production. November 11th the company increased its quarterly dividend 3.2% to $0.1625/share. The dividend is payable January 1, 2011 to stockholders of record December 9, 2010. The ex-dividend date is December 7, 2010. MDU is a Dividend Achiever and has raised its dividend for 20 consecutive years. The yield based on the new payout is 2.06%.

Selecting stocks with increasing dividends is critical for an income growth strategy. The above list contains stocks that recently raised their dividends; it is not a list of recommend buys. As always, due diligence should be performed before buying or selling any stock. For a list of stocks with a long string of consecutive cash dividend increases, see this list.

Full Disclosure: Long ADP. See a list of all my income holdings here.

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(Photo Credit)

This expectation does not change even when the economy turns down and earnings decline; dividend growth investors still require annual dividend growth. The companies that are able to accomplish this are those with a operating model that generates strong free cash flows with room to pay out a higher percentage as dividends. Below are several companies with a low free cash flow payout (below 40%):

An interesting twist to the above is a 2006 study conducted by Credit Suisse that found high dividend yield stocks generally
outperformed those with lower yields. However, the best returns did not come from those with the highest yields, but those with higher yields coupled with low payout ratios. The study found that high yield, low payout stocks that produced the better returns were priced at low ratios of price-to-earnings, and as a corollary, at high ratios of earnings-to-price; i.e., earnings yield. Put another way, the stocks prices were depressed, thus creating the higher yield and a value play. Below are several dividend growth stocks with a higher yields (around 4%+) and low free cash flow payouts (50% and below):

At some point we will all want to retire, but that is not to say we want our portfolio to stop working for us. A good dividend growth stock portfolio will not only provide us income in our retirement, but provide us more income each year than the one before.

Full Disclosure: Long GD, MDT, ADP, PG, INTC, ABT, GPC, TEG, CINF, LLY, HGIC. See a list of all my income holdings here.

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(Photo Credit)

Dividend growth investing is not about exit points, momentum swings, relative strength, sector rotation; instead it is about studying fundamentals, selecting superior stocks and building a portfolio with a long-term horizon.  When we buy a dividend stock, we hope to hold it forever.  What makes a good dividend stock? Here are some of the things I look for:

Good Business Model

Sell things that people want or need, and do it in such a way that it is difficult or impossible for others to duplicate. There is a reason that pharmaceutical companies, such as Abbott Laboratories (ABT), are so profitable. With effective drugs under patent that sustain or enhance people’s life these companies have a deep moat. Consumer goods companies like Procter & Gamble Co. (PG) and Kimberly-Clark Corporation (KMB) manufacture products such as soap, detergent and toilet paper that we just can’t do without. Sure, there may be generic substitutes, but over the years many of these products have endeared themselves to consumers who are willing to pay a few cents more for the name brand.

Strong Free Cash Flow

Dividends are paid with cash remaining after paying the operating expenses and replacement capital (free cash flow). If a company has trouble meeting these basic needs, then its dividend is perilously at risk. Companies with a low free cash flow payout (FCF) payout are well-positioned to sustain their dividend. Such companies include: Target Corporation (TGT) at 13.85% FCF Payout, Diebold, Inc. (DBD) at 17.21%, International Business Machines Corp. (IBM) at 19.48% and Walgreen Company (WAG) at 22.71%.

Acceptable Debt Level

Generating a strong free cash flow is not enough – cash has to be available to be paid as dividends. As a result of the economic downturn, many companies are feeling pressure to reduce debt to stay within their covenants and try to maintain their debt rating. If a company’s excess cash is being used to service debt, there may not be any left over to increase dividends. Companies with a low debt to total capital include: T. Rowe Price Group Inc. (TROW) at 0.00% Debt to Total Capital, Automatic Data Processing Inc. (ADP) at 0.69%, Harleysville Group Inc. (HGIC) at 13.19% and Genuine Parts Company (GPC) at 15.76%.

Good Balance between Dividend Yield and Growth

There is usually a reason why a stock’s yield is above average. Often it is the market’s way of saying it doesn’t believe the company can maintain the dividend. Most people understand this risk. However, there is also risk to a stock that has a high dividend growth rate. To maintain a high dividend growth rate the company has to grow cash available for dividends at the same rate. This is often difficult to do. Here are several companies with a good balance between dividend yield and dividend growth rate: The Coca-Cola Company (KO) 2.94% yield and 7.32% dividend growth rate, UGI Corporation (UGI) 3.06% yield and 5.70% growth, The Clorox Company (CLX) 3.24% yield and 9.35% growth, Johnson & Johnson (JNJ) 3.31% yield and 8.42% growth and Corporate Office Properties (OFC) 4.25% yield and 5.22% growth.

For those of us that have invested in dividends for years (decades for some), we know dividend growth investing is not a passing fad to be “played” then move on the next hot investment strategy. Part of me will be glad when dividend investing falls out of favor and the masses moves on.

Full Disclosure: Long ABT, PG, ADP, HGIC, CLX, GP, JNJ, KMB, KO. See a list of all my income holdings here.

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Jeremy Siegel certainty thinks so based on his recent Wall Street Journal article The Great American Bond Bubble. In the article, he opined that the bond bubble may have far more serious consequences for investors than the internet and technology bubble that burst some 10 years ago. The Nasdaq has yet to recover those losses as it is currently selling at less than half the peak it reached a decade ago.

The longer a bond’s maturity, the more volatile its price. Thus, long and intermediate bonds stand to lose substantially when rates reverse, as noted in the aforementioned article:

If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

Long-Bond Alternatives

Over the next several months I plan to move my bond allocation to those with shorter duration and redeploy excess allocations into quality blue-chip dividend stocks that are yielding in excess of my bond holdings. Consider these dividend stocks that have a current yield in excess of 2.8%:

Let me be clear, I am not predicting the imminent collapse of long-term bonds. As an investor (not a trader), I am not in the prediction business. However, I believe we have reached a point where there is much more to lose than gain by holding long-bonds. Interest rates will eventually rise and for those holding long-term bonds, it will have painful implications.

Full Disclosure: Long PEP, MCD, PG, ADP, JNJ, CVX, KMB, HGIC, LEG, T. See a list of all my income holdings here.

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(Photo Credit)

My goals were defined in this December 1, 2007 Investing Goals post and updated in my 2010 Investing Goals post. Below is an updated version of the table found in the original post.

The above information covers the current month and year-to-date through the current month.

Click here for a Detailed Historical Progress Table.

For the month, annualized dividend income increased $330, and Yield on Cost (YOC) decreased 0.01%. This month’s changes were a net of new purchases and dividend changes (no sales for the month). Let’s examine each of the these categories:

Purchases: The $399 increase in annual dividend income and 0.02% decrease in YOC related to the following purchases (yield at the time of purchase):

• $79 McDonald’s Corp. (MCD) 3.12%  [Analysis]
• $81 General Dynamics Corp. (GD) 2.64% [Analysis]
• $90 Automatic Data Processing, Inc. (ADP) 3.37% [Analysis]
• $149 iShares S&P U.S. Preferred Stock Index (PFF) 5.67%

Only PFF increased my YOC, while three securities lowered it. As noted in earlier updates, I generally expect YOC to drop each month since most new investments will yield less than my current YOC, and dividend increases will not be sufficient to offset it.

Dividend Changes: The $4 decrease in annual dividend income and the 0.03% decrease in YOC related to the following dividend changes (a=dividend stated in annual terms, q=quarterly, m=monthly):

• ($4) Invest Grade Corp Bond (LQD) $5.53a>$5.48a
• $1 Long-Term Bond ETF (BLV) $3.94a>$3.95a
• ($2) Intermediate-Term Bond ETF (BIV) $3.41a>$3.39a
• ($3) Emerging Markets Sovereign Debt (PCY) $1.65a>$1.64a
• $4 Clorox Corporation (CLX) $0.50q>$0.55q

Sales: The $65 decrease in annual dividend income and the 0.04% increase in YOC related to the following sales:

• ($65) AFLAC Inc. (AFL)

This month I exceeded my 2010 goal of $9,500 in annualized dividend income. With four months to go, I am confident of achieving $10,000 in annualized dividend income by December 31, 2010, assuming minimal dividend cuts.

That’s it for this time. The next monthly progress update will be early October.

(Photo: sanja gjenero)

Linked here is a detailed quantitative analysis of Automatic Data Processing Inc. (ADP). Below are some highlights from the above linked analysis:

Company Description: Automatic Data Processing Inc. is one of the world’s largest independent computing services companies, provides a broad range of data processing services.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
2. 20-Year DCF Price
3. Avg. P/E Price
4. Graham Number

ADP is trading at a discount to 1.) and 3.) above. The stock is trading at a slight premium to its calculated fair value of $39.62. ADP did not earn any Stars in this section.

Dividend Analytical Data: In this section there are three possible Stars and three key metrics, see page 2 of the linked PDF for a detailed description:

1. Free Cash Flow Payout
2. Debt To Total Capital
3. Key Metrics
4. Dividend Growth Rate
5. Years of Div. Growth
6. Rolling 4-yr Div. > 15%

ADP earned three Stars in this section for 1.), 2.) and 3.) above. A Star was earned since the Free Cash Flow payout ratio was less than 60% and there were no negative Free Cash Flows over the last 10 years. The stock earned a Star as a result of its most recent Debt to Total Capital being less than 45%. ADP earned a Star for having an acceptable score in at least two of the four Key Metrics measured. The company has paid a cash dividend to shareholders every year since 1974 and has increased its dividend payments for 34 consecutive years.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
2. Years to > MMA

ADP earned a Star in this section for its NPV MMA Diff. of the $522. This amount is in excess of the $500 target I look for in a stock that has increased dividends as long as ADP has. If ADP grows its dividend at 5.5% per year, it will take 3 years to equal a MMA yielding an estimated 20-year average rate of 3.71%. ADP earned a check for the Key Metric ‘Years to >MMA’ since its 3 years is less than the 5 year target.

Other: ADP is a member of the S&P 500, a Dividend Aristocrat and a member of the Broad Dividend Achievers™ Index.

Conclusion: ADP did not earn any Stars in the Fair Value section, earned three Stars in the Dividend Analytical Data section and earned one Star in the Dividend Income vs. MMA section for a total of four Stars. This quantitatively ranks ADP as a 4 Star-Buy.

Using my D4L-PreScreen.xls model, I determined the share price would need to increase to $41.74 before ADP’s NPV MMA Differential decreased to the $500 minimum that I look for in a stock with 34 years of consecutive dividend increases. At that price the stock would yield 3.23%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the target $500 NPV MMA Differential, the calculated rate is 5.4%. This dividend growth rate is virtually the same as the 5.5% used in this analysis, thus not providing any margin of safety. ADP has a risk rating of 1.00 which classifies it as a low risk stock.

A weak economy and low employment levels have negatively impacted ADP, and will likely continue to do so in the near-term. However, as the industry leader ADP enjoys advantages of scale and a respected brand. Financially, the company has a strong balance sheet and steady cash flows from a recurring revenue stream. Recently moving up to a 4-Star rating, ADP is worthy of additional consideration when trading close to my buy price of $39.62. For additional information, including the stock’s dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I was long in ADP (0.8% of my Income Portfolio). See a list of all my income holdings here.

Related Articles:

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- More Stock Analysis

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

Stock Stats

Based on calculations from this past weekend, below are ten stocks with a low risk rating:

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)

Years Of Consecutive Dividend Increases

Inertia is powerful force. Once a company has established a track record of growing its dividend over the decades and developed a shareholder base that expects higher dividends each year, it becomes increasing difficult for management to cut or fail to raise their dividend. No CEO of this type of company wants a dividend cut to occur on his or her watch. There are precious few Dividend Aristocrats remaining and those left enjoy their elite status.

Strong Financial Condition

Dividends are paid with cash, not earnings. The distinction is subtle, but very real. In its pursuit of theoretical perfection, the accounting profession has adulterated the financial statements to the point that it has become very difficult for non-accountants to interpret them. For example, 2009 was a tough year for Nucor (NUE). Its consolidated statement of earnings showed a loss of $237 million, down from 2008′s earnings of $1.8 billion. This decrease in earnings of $2 billion looks devastating until you consider flip over to the consolidated statements of cash flows and realize NUE’s management ran the business to maximize cash generation. The $2 billion decrease in earnings only equated to $688 million dollar decrease in free cash flow and while earnings were negative, free cash flow remained positive at $792 million, more than enough to cover the $443 million dividend payments.

Consider another example. In 2009 Eli Lilly’s (LLY) net earnings improved $6.4 billion, but its free cash flow decreased $2.8 billion. This oddity was primarily the result of how in-process research and development was accounted for. Here is an excerpt from their 2009 10-k describing the accounting:

Most of these acquisitions included IPR&D, which represented compounds, new indications, or line extensions under development that had not yet achieved regulatory approval for marketing. There are several methods that can be used to determine the estimated fair value of the IPR&D acquired in a business combination. We utilized the “income method”, which applies a probability weighting to the estimated future net cash flows that are derived from projected sales revenues and estimated costs. These projections are based on factors such as relevant market size, patent protection, historical pricing of similar products, and expected industry trends. The estimated future net cash flows are then discounted to the present value using an appropriate discount rate. This analysis is performed for each project independently. Pursuant to the existing rules, these acquired IPR&D intangible assets totaling $4.71 billion and $340.5 million in 2008 and 2007, respectively, were expensed immediately subsequent to the acquisition because the products had no alternative future use. The ongoing expenses with respect to each of these products in development are not material to our total research and development expense currently and are not expected to be material to our total research and development expense on an annual basis in the future.

In effect LLY realized a $4.7 billion dollar non-cash charge in 2008, which was an add-back to operating cash flow. There was no similar charge in 2009, thus the substantial increase in earnings.

When evaluating a company’s financial you must also consider competing uses for the free cash flow generated. Many companies generate significant free cash flow, but often that cash is already spoken for in the form of debt obligations. One of the key metrics I look for when evaluating a company is a debt to total capital ratio of 45% or less.

9 Stocks With a Sustainable Dividend

Using my D4L-Data spreadsheet to screen the 170+ stocks that I follow, I limited my search to stocks with the following characteristics:

- Years of consecutive dividend increases > 30 years
- Yield > 3.0%
- Debt to total capital < 45%
- Free Cash Flow Payout < 60%

Below are several stocks that meet the above criteria:

Bonus: Look For A Favorable Industry

Some industries are more stable than others. When the economy turns down and we are concerned about our job, we may discontinue our pest control or lawn service, but we will likely not stop taking our blood pressure medicine. Non-cyclical industries typically include pharmaceuticals,  utilities, defense and certain consumer goods. A company’s ability to grow its dividend is directly related to its ability to grow free cash flow.

Full Disclosure: Long ABT, ADP, GPC, JNJ, LEG, LLY, NUE, NWN. See a list of all my income holdings here.

(Photo Credit)