Investors love dividends because they give them an additional way to make money on a single stock they hold. The other way is through the rise in the value of these stocks. Having a regular annual or quarterly income sounds great for many investors but the problem is that a lot of investors do not know where to start when it comes to finding and investing in great dividend stocks. We are going to explore the world of dividend stocks, looking at what they are, what they entail and how to choose the best dividend stocks.
What are Dividends and Dividend Investing?
Dividends are payments made annually or quarterly (every three months) on the stocks you hold. Usually, a company pays dividends depending on the profits it makes in a financial year or a financial period.
Dividend investing, on the other hand, is having a portfolio of carefully selected stocks that pay a dividend. These stocks are bought and sold as you would other stocks with the difference being their dividend payments. The good thing about dividend investing is that the dividends are paid out whether the company makes a profit or a loss.
Even when the price of a stock falls and a company decides to decrease its dividend payment, the percentage decrease in these payments will always be lower than the percentage decrease in the price of shares. This is the reason why dividends are much better than growth stocks (stocks that do not have a dividend and where investors make money on share price increases).
Key Metrics Investors Should Know
Before we look at how you can choose and invest in dividend stocks, we need to look at some key metrics that will inform your decisions. The first key metric is the dividend yield. This is the percentage of the stock price paid out as dividend. If the stock is trading at $100 and the dividend payment is $2.50, then the dividend yield is 2.5%. Dividend stocks with a high dividend yield such as 5-10% are great, but investors should also consider the company’s ability to keep its dividend yield at this level and ideally increase it over the years.
The next key metric is the payment ratio. This is the percentage of the company’s profits paid out as dividends. While it is always a good idea to look for companies that have a payout ratio of more than 50%, this often means that the company is paying out money that it is not able to invest in itself. The result is the company having an unsustainable payout ratio and you can expect the dividend payments to be less stable in these situations.
The total return is the increase in the price of a share plus all dividends paid in a given period. It is also called capital gains and is something you should keep in mind because it is taxable in many places, with the tax rate depending on a lot of factors and can have a significant effect on your profitability.
The last key metric is the price-to-earnings (P/E) ratio. The P/E ratio is the ratio of the share price to the earning per share. Earnings per share is calculated by dividing the company’s net profit by its outstanding shares. When earnings per share increase, that shows the company is making a profit and so the dividend stocks you hold will keep performing well. The P/E ratio, earnings per share and dividend yield can be used together to determine if a stock is valued well, if its dividend price is sustainable and if it is generally a good stock to invest in.
Start By Looking at the Company Itself
Before investing in a dividend stock, you should have a close look at the company beforehand. The best dividend stocks are those of later, stable, more established businesses and companies. These are the businesses and companies that are a lot more likely to have stable revenues and therefore stable dividend payments. Additionally, profitable companies increase their dividends every year or period because they no longer need money to do aggressive expansions and so they can channel more money to their dividend payments.
Understand What the Company Does
An important rule of investing is that you should always understand what the companies you are investing in do. Before buying dividend stocks, it is important to find out what the company’s business model is and whether it is sustainable.
Instead of focusing entirely on the dividend payout, also look at what the company does, what products and services it sells, how its products and services are doing in the market, how they operate and other aspects that give you a glimpse into their business model.
A company on the decline cannot sustain dividend payouts in the long term. A point to note here is that companies can undergo a short period of deterioration. If this downturn is short term and the company has a strong history, it’s generally okay to overlook this decline. However, if there are underlying issues such as the company products not being in demand anymore, then you should pass.
Stay Away from Companies In Debt
When looking at the different companies whose stock you can invest in, try to find out if the company has any debt. This is because companies that have a lot of debt will choose to put money into repaying these debts rather than paying out a dividend. The dividend price may stagnate or even fall as the company does this and so you should check the company’s debt-to-equity ratio. Anything above 2.0 is a red flag that you should pay attention to.
In addition to debt, you should also check that the company has low capital expenditures. High capital expenditure means that the company has to use a lot of its revenue for continuous reinvestment in the business. A good example is the airline industry where companies have to invest in new planes and routes. When a company spends so much money on itself (high capital expenditure) it means it has a lot less money to invest in dividend payouts.
Pick a Few Stocks in Growing Industries
Although the consensus is to go with more established companies and businesses, there is a lot of potential in investing in growing industries. The best example is renewable energy companies that offer dividend stocks. The green and renewable energy industry is still growing and so there is a lot of potential for those who get in right now. The companies in this industry are projected to keep growing their revenues, meaning that even though their dividend payments may not be the highest right now, they will keep increasing year over year.
That said, it is still possible to find the highest dividend stocks through services like Wealthsimple. Wealthsimple has already curated the best dividend stocks to invest in today, ensuring that they are the highest dividend stocks and that they are in growing and established industries so that you have a great mix of stocks in your portfolio. Wealthsimple also makes it easy to invest in these dividend stocks through their commission-free trading platform and they have real humans standing by to answer any questions you have, offer advice or even help you make your first investment.
Check the Historical Dividend Growth Rate
The past remains one of the best ways to judge the future, especially when investing. Specifically, what you should be looking for is growth in dividend payouts. If a company has not been increasing its dividend payouts in the past, there is no assurance that it will do so in the future. This means that your investment will stagnate.
Investors should check the dividend growth rate for the last 1, 3, 5 and 10 years. Dividend stocks that have an annual growth rate of 5-10% are great candidates. Remember to factor in the dividend yield before deciding on a stock. If a stock has a low dividend yield, it should have a high dividend growth rate. This is especially true for newer industries such as the green and renewable energy industry discussed above.
Check the Dividend Payout Ratio
Stable companies will channel most of their profits to dividend payouts. This is also true for companies that have little debt or whose revenues are growing. The best dividend stocks to invest in are those for companies that have a dividend payout ratio of over 50%.
Check Dividend Payment Consistency
Consistent payouts are important especially for investors who would like to use their dividend stocks to earn a passive income. There is no need to invest in a company that ticks most or all of the boxes above and that pays dividends inconsistently. This might be a management or cash flow issue but in either case, you should stay away from their stocks.
Choosing and investing in dividend stocks might seem confusing and complicated for many investors but it is not much different from buying growth stock. The most important thing to remember is that proper, in-depth research will help you a lot and save you a lot of headaches and disappointment down the road.