How to Choose the Best Dividend Paying Stocks
Dividend-paying stocks can be a powerful investment tool with the potential to compound your growth when the dividends are reinvested using a dividend reinvestment plan (DRIP). However, not all the stocks that pay dividends are created equal. Consequently, there are several metrics that you should consider before purchasing dividend stocks. If you employ a few simple evaluation criteria, you will be able to select quality stocks with a proven track record that provide consistent passive income.
What to Look for When Buying Dividend Stocks
While there are innumerable criteria you could consider when purchasing dividend stocks, focusing on a few criteria will enable you to choose high-quality stocks without experiencing information overload. Here are some of the important criteria to consider:
- Dividend yield
- Dividend Payout ratio
- Dividend Growth history
- Debt Ratio
Dividend Yield
The dividend yield is the amount your initial investment will return in dividends in a year. It is calculated based on the annual dividend and the purchase price of the stock. For example, if you purchase a $60 stock with an annual dividend of $3, the dividend yield is 5%, which is calculated by dividing the annual dividend by the price. All other factors being equal, the higher the dividend yield, the better, as your initial investment will be returning a greater amount. However, this is where the other evaluation criteria come into play. If you evaluate a stock solely based on the dividend yield, you will be blind to some pitfalls that may make the stock a poor investment.
Dividend Payout Ratio
After looking at the dividend yield, you will want to see the company’s payout ratio. This represents the amount of the company’s net income that is being paid to investors in dividends. For example, if a company has a payout ratio of 50%, then the company is paying half of its net income to its shareholders in the form of dividends. All else being equal, a smaller payout ratio is preferable. The reason why a smaller payout ratio is desirable is because the company will have more capital available to invest in growth and there is a higher probability that the dividends are sustainable. If a company has a dividend payout ratio of 20%, then a short-term financial hardship is unlikely to result in a reduced dividend being paid to shareholders. In contrast, if a company has a very high payout ratio, such as 80%, then it will likely have to tap into the dividends if earnings drop or a capital-intensive situation arises. It is important to realize that money paid to shareholders reduces the money available to invest in growing the company. This is why companies heavily focused on growth either pay no dividends or very low dividends. Amazon is an excellent example of a company that funnels its money into expansion, and the results have been impressive.
Dividend Growth History
Another important dividend stock evaluation criterion is growth history. A company with a history of increasing its dividends every year over a substantial period, such as several decades, is a likely indicator that you can expect future dividend increases and that the company is committed to sharing its success with the shareholders. Dividend giants, such as Coca-Cola, have demonstrated consecutive dividend increases for over half a century. This proven track record is a great indicator of continued dividend growth. As dividends increase, your dividend yield on the initial investment also becomes more attractive. Consider the $60 stock with a $3 dividend yield, if the dividend increases by 10% the following year, the stock will payout $3.30, which means the original 5% yield on your $60 investment becomes a 5.5% yield. This is not always readily apparent because you typically also see an appreciation in the stock price, which makes the increased yield less apparent. For example, if the stock price increased to $66, then the dividend yield for the stock would still be expressed as 5% ($3.30 divided by $66); however, because you purchased the stock at a lower price, your yield is higher.
Debt Ratio
Before rushing out and buying a stock with a high dividend yield and a strong history of growth, you should also look at the debt. Debt is evaluated using the company debt ratio, which is calculated by dividing the total liabilities by the total assets. Liabilities are obligations to others (i.e. debt), and assets are items of value. For example, a bank loan is a liability, while a manufacturing plant is an asset. You should avoid investing in companies if the debt ratio is too high. All else being equal, the lower debt ratio is preferred.
Conclusion
Adding dividend stocks to your portfolio can provide a reliable source of passive income, especially if you utilize a dividend reinvestment program. However, you must carefully evaluate each stock purchase to validate the quality of the company. A high dividend may be enticing, but if the company’s underlying financials are unattractive, they are unlikely to sustain the dividend payout. Some factors to consider before buying a dividend stock are the dividend yield, the dividend payout ratio, the dividend growth history, and the debt ratio. If you can find a stock with a high dividend yield, low dividend payout ratio, strong history of dividend growth, and low debt ratio, then it has the potential to be a dividend-producing powerhouse.
