Dividend investing can do wonders for your investment portfolio.
Besides the potential for capital returns, dividend investing also provides investors an income stream that can increase over time.
With this enticing possibility, how does one then find good dividend stocks to invest in?
If you ask me, I think it simply comes down to these five parameters:
- Good financial performance
- Financially healthy and stable
- Sustainable dividends
- Good growth prospects
- Acceptable yield and valuation
Let’s go into a little more detail for each aspect.
Good financial performance
Simply put, no company can pay out increasing dividends over the long run if they are not performing well in their respective businesses.
Thus, the first thing investors would want to look at is the financial performance of the company over at least the past five or ten years.
Has the company’s revenue and underlying profit grown over the past five or ten years? Has its free cash flow also increased in tandem? These figures can all be sourced from the company’s income and cash flow statement.
A good financial performance over the past few years increases the likelihood that a company can not only continue paying out dividends, but also increase them over time.
Financially healthy and stable
In addition to good financial performance, it’s also important that a company is financially healthy and stable. After all, how can investors expect a company to pay out dividends if it is not financially stable?
To assess a company’s financial health, investors can look at the company’s balance sheet.
Is the company able to pay off its current liabilities? What is the company’s debt profile? Is it overly-leveraged?
Some useful financial ratios that investors can use to assess financial health are the quick ratio, current ratio, debt-to-tangible asset ratio and debt-to-equity ratio.
Sustainable dividend payout
After assessing the financial performance and health of the company, investors should look into the dividend payout of the company.
Since dividends are cash paid out by a company from its business operations, investors should assess if dividends can be sustained by the company’s free cash flow. If dividends are comfortably sustained by free cash flow, there is a higher probability that dividends paid out can increase over time.
To assess the sustainability of a company’s dividends, investors can look at the cash flow statement and divide the dividends paid out by the amount of free cash flow generated. A value greater than 1 means that the dividends paid out are not fully covered by the free cash flow. Over a prolonged period, this could lead to a decrease or even the outright suspension of dividends paid out.
It should be noted that an unsustainable dividend payout might not naturally make a stock a bad dividend play, as some companies use debt to fund a portion of their capital expenditure that has a direct positive impact on future cash flows. The key here is for investors to assess whether the debt used can positively improve future cash flows or is used to simply sustain the daily operations of the company.
Good growth prospects
Moving past the financial numbers of the company, investors should then assess the company’s growth prospects.
Is there growth in the company’s respective sector and industry? Is the company poised to benefit from any industry trends? What are the growth conditions of the company’s geographical and revenue segments?
By looking at the company’s prospects, investors would then be able to assess the probability of its continued positive performance and whether there is room for dividends to increase over time.
Now I will be first to admit that this parameter of prospects could be a hit or miss at times as it can easily be influenced by macroeconomic or geopolitical factors. Nevertheless, if you had invested in a company with a sustainable dividend payout, it does afford you some margin of error should you get the company prospects wrong.
Acceptable yield and valuation
The last aspect to consider for dividend stocks would be the yield and corresponding valuation. This is crucial as entering at too high a valuation could severely impact your overall returns as dividend stocks do not normally see high amounts of capital gains as compared to growth stocks.
When investing in dividend stocks, investors should always compare the yield to the ‘risk-free’ rate. By doing so, investors would be able to assess if the yield premium is proportionate to the risk of investing in the stock.
For instance, if the ‘risk-free’ rate is 3%, then it might not make sense to invest in a dividend stock that has a yield of 3.2% since that 0.2% yield premium is not commensurate with the risk taken. Of course, this could change if the company is in a high-growth stage, which is why investors need to consider the previously mentioned four parameters too.
Besides the stock’s dividend yield, investors can also use other valuation methods such as discounted cashflow or price-to-earnings ratio to determine if a dividend stock is worth investing in.
Personally, I would consider both the dividend yield and forward price-to-earnings ratio when determining an entry price for dividend stocks.
Conclusion
By considering these five parameters, I think it provides a solid foundation for building a sustainable long-term dividend portfolio. Do note that you have to also constantly review your dividend picks to ensure that they continue to perform within your expectations.
If you are interested in finding out how to analyse another dividend-providing asset class which is REITs, you can find out more from my 8-step REIT analysis guide.