Selecting Dividend Stocks
Screen reliable dividend growth equities using free cash flow payout coverage, balance sheet strength, and dividend history metrics.
TL;DR
- Prioritize consistent compound
dividend-growthover risky high static yield. - Screen annual corporate payouts using conservative
free-cash-flowcoverage metrics. - Avoid distressed high-yield
value-trapswith deteriorating corporate balance sheets.
Dividend Aristocrats And Champions
Dividend ContendersFirms with 10 to 24 consecutive years of annual dividend hikes.
Check whether streak is at least 10 and streak is less than 25.Dividend AristocratsS&P 500 members with 25+ consecutive years of annual hikes.
Check whether in sp500 and streak years is at least 25.Dividend KingsRare global corporations with 50+ consecutive years of hikes.
Check whether streak years is at least 50.Financial Health Screening Filters
Free Cash Flow PayoutDividends covered comfortably by operating cash minus capex.
Dividends covered comfortably by operating cash minus capex.Interest Coverage RatioOperating earnings multiple relative to annual debt interest.
Check whether ebit divided by interest expense is at least 4.0.Return on Invested CapitalHigh capital efficiency creates excess cash for distribution growth.
Check whether nopat divided by invested capital is at least 0.12.Identifying Deceptive Yield Traps
Artificial Yield SpikesCurrent yield doubles because underlying stock price collapsed.
Current yield doubles because underlying stock price collapsed.Payout Over 100 PercentCompany funds dividends by issuing debt or selling capital assets.
Check whether total dividends is greater than net income.Eroding Top-Line RevenueDeclining sales will eventually force executive dividend cuts.
Check whether rev3yr cagr is less than 0.Portfolio Construction For Dividend Growth
Sector DiversificationCap individual sector weights at 20% to avoid utility concentration.
Set sector diversification to 0.20.Chowder Rule ScoreSum of current dividend yield and 5-year dividend CAGR.
Check whether yield pct plus dgr5yr pct is at least 12.Position Sizing CeilingLimit single company holdings to 4% of total equity value.
Set position sizing ceiling to total equity times 0.04.Tips
- Use the
Chowder-Ruleto evaluate dividend stocks by summing current yield and 5-year dividend growth rates. - Screen for companies with an investment-grade
credit-ratingof BBB+ or better to protect principal during crises.
Warnings
- Never evaluate a high-yield stock without checking if the firm is funding payouts through
debt-issuance. - Beware of high headline yields caused by a collapsing
stock-pricefollowing fundamental business deterioration.
In Practice
Verify corporate dividend coverage using free cash flow payout ratios.
A company reports $120 million in free cash flow, $40 million in GAAP net income, and pays out $30 million in annual dividends.
- 1. Calculate net income payout ratio: $30M dividends / $40M net income = 75.0%.
- 2. Calculate free cash flow payout ratio: $30M dividends / $120M free cash flow = 25.0%.
- 3. Compare FCF payout ratio to the 60% warning threshold: 25% is safely below 60%.
- 4. Model 7% annual dividend growth over 5 years: $30M * (1.07)^5 = $42.08 million.
- 5. Verify projected payout against current FCF: $42.08M / $120M = 35.1% coverage.
Dividend coverage remains highly secure with free cash flow payout at 25.0%.
Free cash flow payout ratio provides a truer measure of dividend sustainability than net income.
FAQ
The Chowder Rule is a popular dividend growth heuristic created by investor Lowell Miller. For stocks with yields over 3%, the sum of current yield plus the 5-year dividend growth rate should exceed 12%. For utilities or lower yielding firms, target thresholds adjust accordingly.
GAAP net income includes non-cash items such as depreciation, amortization, and one-off accounting write-downs that can distort true profitability. Free cash flow represents the literal cash generated after capital expenditures available to pay shareholders.
A portfolio of 20 to 30 well-diversified individual dividend stocks across multiple economic sectors captures most idiosyncratic risk reduction without creating an unmanageable research burden.