Investors love dividends. These quarterly chunks of change add up over time and, for income investors, can make a big difference in long-haul investment yield. Once you retire, these dividend checks can be diverted straight to your bank account to help fund your spending needs. What’s not to love?
Before we make an income-based investment, we want to take a good look under the hood to see what’s really there. When choosing companies for their dividend payouts, it’s important to consider more than the flashy exterior. After all, not all blue-chip stocks were created equal.
The infinite amount of ways to screen companies can be daunting – there are hundreds of different variables, inflection points of these variables, and so forth. But, you don’t have to run equation after equation to choose a high-quality blue-chip stock. You just need to apply a few fundamental principles in your selection process.
To find a blue chip that will withstand the test of time, you can start by using this approach, which is a rough sketch of how we at Capital Investment Advisors choose stocks.
Begin by looking into the S&P 500 universe. Screen for all that fit into the $5 billion and above category. That’s easy enough to do.
Next, look for the companies that have reasonable forward P/E (price to earnings) multiples in the realm of 20x or less. Once you’ve whittled your list, eliminate the companies that aren’t healthily growing their dividends – you’re looking for 4% growth or more each year.
Then you want to screen for a particular free cash flow (FCF) level relative to the company’s size and debt levels. This metric is the company’s operating cash flow, or capital expenditures minus acquisitions.
Why do we use this variable? Because it’s a good way to get a handle on the cash generated by the business after adjusting for the cost needed for ongoing investments. We exclude acquisitions because they tend to be one-time expenses and don’t accurately reflect the “iron-clad” number required to keep the business going. FCF is what can be used to buy back stocks, pay dividends, reduce debt, buy other companies, etc.
For the final phase in the selection process, look at other metrics that measure the company’s earnings relative to debt to help you get a sense of how the company is performing. And then, voila! You’re done!
What you should have now is a basket of companies that are attractively priced with nicely growing dividends. This is the kind of company I want to own in a downturn… and in a market upswing.
Now, if you want more details or guidance, don’t hesitate to reach out. As always, the team here at Capital Investment Advisors is here to help you with your investment needs.