Dividend Stocks – Introduction
Dividend stocks are popular amongst investors entering retirement, as well as younger long-term investors.
These investors like to take advantage of regular cash payments and the steady income they can provide!
Dividend stocks offer you the opportunity to receive cash payments for share ownership and to reinvest those proceeds into more shares! This slow and steady method of investing can help you build real wealth over time!
In this post, we’ll break down a good process to use when searching for the best dividend stocks to add to your portfolio!
Dividend Stocks – Strong Track Record of Dividend Payments
As a dividend stock investor, dividend payments are the lifeline of your strategy.
When searching for the right stocks to invest in, you will want to focus on companies with a long history of increasing dividend payments.
This track record shows managements commitment to sustain and continuously deliver dividends to shareholders.
You can pull up the dividend payment history for most publicly listed companies information up on Google by typing in the company name followed by dividend payment history.
There is a select group of dividend-paying companies known as the “Dividend Aristocrats” in the industry. This select group of 57 S&P 500 companies has each recorded 25+ years of consecutive dividend increases. Some of the names in this group include Coca-Cola, Johnson & Johnson, AT&T, as well as Exxon Mobile.
Some things to consider while studying the dividend payment history:
How long has the company been paying dividends? You’ll want to look for at least 3 years of payment history, however, 5+ years is more desirable. We also want to see consistent dividend increases over the last 5 years.
Are the dividends increasing on a yearly basis? Have they increased yearly for the last 5 years or more? These are signs of a financially stable company that you should focus on.
Are there any discrepancies in the dividend history? Were dividend payments ever halted at any point in time? Have there been any cuts to the dividend payments?
If you come across any of these red flags during your research, it is better to stay away! The reason for this is because when a company announces dividend cuts or halts, it is often a warning signal that rough waters are up ahead.
Remember that dividends are not mandatory! They are never guaranteed and just because a company has historically paid out a dividend, that doesn’t mean that they will continue to do so forever!
The best thing you can do is put the probability in your favor! So stick with the above principles and you’ve got this step covered.
Dividend Stocks – What is the ideal Dividend Yield to aim for?
There is nothing set in stone with this one!
Depending on the sector you’re looking at and the style of stock, the averages are going to be all over the place.
A general rule of thumb is to aim for stocks somewhere in the range of approximately 2-4% .
You don’t want to be investing in stocks with too low of a dividend because the amount of income you will be receiving will be insubstantial.
At the same time, you don’t want to be investing in stocks with too high of a dividend for two main reasons:
(1) If a company is paying an extremely high dividend, you have to ask yourself can they sustain that dividend? Can the company afford to pay a 7-9% yield?
(2) Even if they can afford it, is it the best use of their money? Is management using their capital wisely or effectively? Maybe they’d be better offer reinvesting some of that back into the company. With that said, we tend to proceed with caution when we see a yield above 5%.
If you want to take a look at the companies numbers, these are four important metrics when choosing a dividend stock.
Dividend Stocks – #1 – Profits Matter!
The first order of business when analyzing a company is the companies ability to make money. Is this company selling products or services? Is this company consistently making money?
There is a big difference between a one-off year and a company that just can’t seem to post a profit year over year.
Companies in volatile sectors like the energy sector will often have a rough year here and there due to economic factors or whatever the case may be. But that doesn’t necessarily mean that this is a bad company and that it’s poorly managed.
A big red flag that should be avoided is any company that is consistently losing money.
Instead, you want companies that get just a little more profitable than last year. Consistency is key!
At a minimum, you want a company that has been generating positive earnings without losses for the last 5 years. On top of that, the company should have long term growth expectations in the neighborhood of 6-8%.
High growth expectations can do quite a bit of harm once a company starts to mature and earnings start to miss! A realistic approach to expectations will keep you onside with companies that are consistently profitable and likely to continue growing in profitability.
While positive earnings play their role in fueling profitable growth, cash flow is what pays for those dividends. Let’s take a look at this in the next step.
Dividend Stocks – #2 – Stable & Sustainable Cash Flow
As the name implies, cash flow is the companies ability to generate a stream of cash into the company such as liquid assets, cash, and cash equivalents.
Consistent cash flows provide management with the flexibility to know how much money is coming in and how much the company can pay out in dividends. to allocate firm capital and pay out dividends.
Companies in the banking, consumer staples, and utilities sectors tend to have a reputation for maintaining positive cash flow through good and bad economic cycles.
You want to find companies that are diversified in the products or services that they sell and have many streams of income. This diversification will help companies sustain and grow products throughout the economic cycles.
If you are really into diving into numbers, you can check out the cash flow statements of most publicly listed companies on Yahoo or Google finance. Here you can make sure that the company has enough cash to cover liabilities and the dividend without running into problems.
Dividend Stocks – #3 – Dividend Payout Ratio
The payout ratio is the portion of the companies profit or earnings that they pay out in dividends. This will be displayed in percentage form.
For a detailed explanation of the dividend payout ratio, check this post here
Let’s walk through a quick example:
If a company makes $100 in income and pays $50 in dividends, the payout ratio will be 50%.
If a company makes $100 in income and pays $70 in dividends, the payout ration will be 70%.
This is a very important metric to understand. Let’s say you found a stock that was paying a 5% dividend. You may be thinking Wow! What a great investment!
But if you took a look at the payout ratio and if it’s payout ratio was something like 150-200%, then what that tells us is that the company is paying out more in dividends that what they are bringing in.
Maybe they are dipping into their cash reserves or taking on additional debt to finance these dividends. So that’s something you’ll want to keep an eye out for!
Now is there an ideal range for the payout ratio? Well, it varies from industry to industry and there is no set threshold, but in general, we like to see a payout ratio below 60%. This allows management to reinvest the rest into the company’s business for future growth. Remember, if a firm pays too much of its profit, it may hurt its own competitive position!
Dividend Stocks – #4 – Excessive Debt is Toxic!
Dividend-paying companies with excessive debt should be avoided at all costs!
If a company holds excessive debt, it will likely have to pay it down at some point in time. In this scenario, any extra cash would be going towards the deleveraging effort instead of dividends.
This puts dividend investors at risk of a dividend cut or halt! Something we hope to stay away from!
The debt-to-equity ratio provides us with a quick way to determine a company’s debt situation.
To calculate the debt to equity ratio, you simply divide a companies liabilities by the equity.
Ideally, you are looking for a debt-to-equity ratio below 1.00 as this means the company will have $1 of equity for each $1 of liability. You will, however, want to disqualify companies with debt-to-equity ratios above 2 as these companies are overleveraged and present greater risks to investors.
Dividend Stocks – The Bottom Line
When looking to invest in dividend stocks, you will want to look focus on profitable companies with a strong track record of earnings growth and increasing dividend payments. In addition to this, we prefer to see a low debt-to-equity ratio and a reasonable dividend payout ratio. Once we’ve qualified a stocks that meets all of our parameters, it’s time to consider setting up a DRIP pan.
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.