How to use StockRanks to find dividend growth stocks

How should investors looking to build a portfolio of dividend growth shares use the StockRanks? 

A high StockRank is a good starting point. Highly-ranked shares are statistically more likely to outperform the market and should generally be in good financial health. While dividends are never guaranteed, this will make it more likely that any dividend offered will be affordable and sustainable.

However, one challenge with using the StockRanks to look for income opportunities is that a stock’s rank does not tell you anything about its dividend yield or dividend growth rate.

There are some good reasons for this, as we’ll explain below. But for investors wanting to generate income from their portfolios, the StockRank’s agnostic approach to dividends means that it can be useful to screen for some additional information alongside the StockRanks when selecting stocks. 

In the first of this two-part series, we’ll look at how you can use the StockRanks and other data available in Stockopedia to screen for attractive dividend growth shares. In part two, we’ll adapt this approach to look for shares with high dividend yields.

However, before we go any further, it’s worth taking a moment to consider why the StockRanks don’t distinguish between dividend payers and non-payers.

Are dividends irrelevant?

In the 1960s, economists Merton Miller and Franco Modigliani developed the dividend irrelevance theory. 

This suggests that investment returns will be determined by companies’ earnings growth and capital allocation decisions. They believed shareholders should be indifferent to whether they received returns through capital gains or dividends, because the end result would be the same.

To some extent, this theoretical view is borne out by reality. For example, when stocks go ex-dividend, they typically fall by (approximately) the amount of the dividend that is to be paid. The cash return has been subtracted from the share price to give a neutral overall result.

Since the 1960s, it has become increasingly popular for growing companies to argue that they can generate higher returns for shareholders by reinvesting surplus cash than by paying it out as dividends. 

For smaller, fast-growing companies, this is often true. But as companies move beyond this point, one alternative viewpoint is that dividends provide a useful discipline for management (who are often not major shareholders). 

Rather than being free to reinvest all surplus earnings in new capital projects, paying a dividend means that management must reserve a proportion of surplus cash for shareholders. 

The allocation of the remaining surplus capital must therefore be more carefully considered, in order to find the best opportunities and avoid risks that could lead to the future cancellation of the dividend.

For these reasons, some investors believe that well-supported and regular dividends are a sign of good management. Such companies can often continue to deliver sustainable growth for longer than expected.

From a shareholder perspective, a growing dividend provides a useful income and may make it easier to continue holding a stock through periods of market volatility.

What’s a dividend growth stock? 

Dividend growth stocks are typically businesses that are well established and profitable, but still have room to grow. This might mean gaining market share in existing markets, or expanding into new markets.

How does this translate into dividend metrics? Investors should set their own requirements for income yield and growth, but we would suggest the following as a starting point:

• A dividend yield that’s comparable with risk–free cash saving interest rates

• Dividend growth rate equal to or greater than inflation.

Based on conditions in the UK at the time of writing, this might equate to:

• Dividend yield of 3%-5%

• Recent and forecast dividend growth of at least 4% per year

Share price gains + income: by focusing on growth as well as yield, we’re targeting stocks with the ability to deliver share price gains as well as income. Theoretically, at least, the expected total return from a share is equivalent to its dividend yield plus expected dividend growth rate.

For example, a share with a 4% dividend yield and 6% forecast dividend growth rate would have an expected annual return of 10%. This would be made up of 4% income and 6% share price gains.

The logic behind this is that a stock’s valuation can be represented by a dividend yield. For the yield to remain constant, its share price must rise in proportion to the growth of its dividend.

This isn’t an exact relationship, of course, and many other factors affect stock valuations. But expected return can be a useful metric to use when assessing the outlook for shares.

Finding dividend growth stocks

To find shares with strong fundamentals, growth potential and income we’d suggest using a combination of the StockRanks and some simple screening metrics. 

When used consistently, a screen-based investing approach can deliver good results, as we’ve discussed here. But it’s worth reiterating that screen results should generally be viewed as a list of shares for further research, not a list of stocks to buy.

In addition, most screens will not always deliver a consistent number of results and may not capture every stock that may be of interest. 

With these caveats in mind, we believe the StockRanks and screening criteria discussed below could be a useful way to start building a portfolio of good quality dividend growth stocks:

StockRank >60: since the inception of the StockRanks in 2013, shares with StockRanks of 60 or higher have collectively outperformed the FTSE All-Share index (April ‘24/view latest performance data here).

MomentumRank >60: shares with strong momentum scores are typically benefiting from upgraded broker earnings estimates and positive share price action. These can be a good predictor of sustainable dividend growth.

Although earnings and dividend growth can occur without these positive factors, such situations are less common and may have other complications. 

Dividend yield (rolling) > 2.5% & Dividend yield (rolling) < 5%: combining these two rules allows us to select stocks with dividend yields in the range that we are looking for – comparable with cash savings interest rates. Appropriate values may vary over time.

Dividend per share growth forecast (1y) greater than 4%: this is an example chosen to reflect (perhaps) a typical rate of UK inflation. The required dividend growth rate from a stock will vary depending on inflation and investors’ own requirements. 

Dividend per share CAGR (3y): a company’s dividend track record can be a useful indicator of how it might perform in the future. If the payout hasn’t risen over the last three years, then investors may want to question whether it is likely to increase over the next three years.

Dividend cover (rolling) > 1: dividend cover compares a company’s dividend payout to earnings per share. In theory, a cover ratio of one would probably be low for a dividend growth stock, as it might imply that a company has now capacity to reinvest any of its earnings for growth. In most cases, a figure of 1.5  (or higher) might be more desirable.

However, earnings can fluctuate from year to year. If screening rules are too restrictive, they may exclude stocks that could be of interest. Where a stock’s dividend cover ratio is low, it is worth investigating further to understand why. 

For example, the business may have a large cash pile or very low capex requirements. In such cases, a high payout ratio might still be compatible with strong growth prospects.

Next steps

These screening rules are intended to be an example of a StockRank-based approach for highlighting attractive dividend growth shares. We’d encourage you to experiment with different screening values and criteria in order to understand the impact of each rule.

There are also other factors that may be worth investigating before making any investment decisions. These might include cash flow coverage for the dividend, profitability and debt levels. 

It can also be useful to spend time understanding a company’s business model, in order to assess its growth potential and any risks it may be facing.

A dividend growth approach can be a rewarding long-term strategy for investing with the potential to deliver attractive compound gains over many years. Focusing on dividend growth stocks may also be useful as part of a value-momentum strategy, even over shorter periods.