Wednesday, June 7, 2023

Beyond PADI

Every November when it comes time to renew the domain name for this blog, I promise myself that I'll write more in the new year. My best intentions usually lose steam in late January or early February. In order to recreate the spark, here is the fourth of what could best be described as 15 30-minute, quantity over quality, blog entries. 

Recently at work, a colleague and I conducted the second round of interviews for credit analysts, talking to six candidates. The last question we asked each candidate was “What do you feel is the best ratio to determine the credit worthiness of a company?” The question got me thinking about what the most important ratio would be to assess the health of an investment portfolio.

In the dividend growth investing space, based on what I see on blogs and Twitter, projected annual dividend income (“PADI”) seems to be the most popular ratio. Having used the PADI ratio as one of three metrics I calculate to assess my portfolio, I can see the draw. The number is precise, pretty easy to calculate, and its growth over time gives the impression that your portfolio is on the right track. That said, PADI can also mask the fact that you might be reaching for yield, or that you are simply adding lots of dollars to your investments. Importantly, PADI also assumes that dividend cuts don’t happen, which has not been my experience in the near 20 years I have invested in stocks.


The two other metrics that I use to assess the performance of my portfolio are dollar-weighted, organic dividend growth rate and portfolio IRR. The organic dividend growth rate keeps me honest in terms of limiting the number of times I reach for higher yielding stocks, while the IRR incorporates any inflows/outflows to/from my portfolio. Of these two ratios, the organic dividend growth rate is easier to manipulate, as I could choose to invest only in companies that grow their dividends at a rapid rate, or sell any company that cuts their dividend before the next time I calculate the ratio.

In case you’re wondering, there was no “right answer” to the interview question, we simply wanted the candidates to justify their responses. The answers were varied, but the depth of understanding the candidates showed by elaborating on their responses allowed us to differentiate the applicants. Similarly, I don’t feel that PADI is the perfect measure to assess portfolio health, given the wealth of other options available (without having even mentioned portfolio yield, various value metrics, FCF yield, etc.), so long as you’re able to explain why you choose other ratios to calculate. Like most aspects of investing, the metrics you choose to use should be relevant for you, and help you achieve your long-term goals.