Learn about dividend investing and how dividend paying securities can be used to create a diversified portfolio with a regular stream of income.
How dividend investing works?
Dividend investing is an investment strategy where the investor specifically chooses to purchase shares of companies that make dividend payments. Companies will pay dividends when they have excess cash flow after covering operating expenses and capital requirements for business reinvestment.
The idea behind this strategy is that only stable mature companies that generate reliable earnings will be able to pay dividends and increase them over time. These companies will most likely have the financial ability to weather setbacks.
There are also companies that could pay dividends but have instead chosen to reinvest their profits within the company in other growth projects. Perhaps one day they will elect to pay dividends but since they don’t these stocks are excluded for dividend investing. Poorly managed companies or those not yet profitable who could potentially fail may not pay dividends and thus are not considered for this type of strategy.
Investors who adhere to this strategy need to consider what to do with their dividend payments. There are generally three options:
1. The investor uses the cash dividends from their portfolio as a form of income, all or part of the dividends are used.
2. The investor reinvests the dividends into additional shares using a DRIP.
3. The investor can pool the dividends and buy new holdings of dividend paying securities to keep growing their portfolio.
What to look for in dividend paying securities?
The analogy of having a solid foundation when building a house can also be applied with creating a dividend investment strategy. In this case, the following three common criteria listed below can be used as a starting point.
1. Dividend Yield
Most investors will begin their search by looking at the yield on dividend paying securities which vary by sector and industry. When comparing yields between companies, the investor should make sure the stocks are in the same sector or industry to compare apples to apples.
Dividend Yield = Annual Dividend / Current Share Price
As the share price increases or decreases, the dividend yield will fluctuate.
Another factor that will affect the dividend yield is if the dividend is increased or cut. When screening stocks based on yield, an investor can indicate a range or select a minimum yield as a cutoff.
- A low yield should not automatically disqualify a stock because of the potential for future dividend increases.
- An unusually high yield versus other similar stocks can be a warning sign, proceed with caution. The stock price could have declined because the market believes that the dividend will be cut because of financial problems.
Should I purchase a low or high dividend paying security?
It depends, for many, the decision will be partially based on their need for current income versus potential growth of dividends.
2. Dividend Payout Ratio
Once an investor has their list of stocks based on yield, the list can be further refined by looking at the dividend payout ratio. The payout ratio can be a good indicator of the sustainability of the dividend and whether the company can continue to pay the dividend but also have the ability to increase them over time.
Dividend Payout Ratio (DPR) = Dividends per share (DPS) |Earnings per share (EPS)
This ratio indicates the amount in percentage of the company’s income paid out as dividends to shareholders, while the difference is kept within the company for other purposes. Take into consideration that the payout ratio can vary from one industry to another or if a company is in a growth or mature phase of its life cycle.
All else being equal an investor would prefer a stock with a lower or declining payout ratio because it provides the company with flexibility to invest and grow its dividends over time or provide a buffer during difficult times.
3. Dividend Growth Rate
Investors will want to know which companies have increased their dividends in the last few years and by how much. Many investors will look at the dividend growth rate over a 5-year average to get a longer-term view of the dividend history.
Dividend Growth Rate 5 Year Average is the percentage change of the cash dividend paid to common shareholders over the past five years. The change will be positive if the dividend increased or negative if the dividend was reduced.
A rule of thumb is that the 5-year dividend growth rate should at least keep up with inflation but preferably be higher in order not to erode your buying power.
Investigate exaggerated dividend growth rates, it could indicate companies paying special one-time dividends or cyclical stocks temporarily increasing their dividends during a bonanza.
Starting with these three dividend screening criteria, yield, payout ratio and growth rate, an investor can create a basic dividend portfolio with regular payments and the potential for additional dividend increases.
What tools can I use to find dividend paying stocks?
Use tools like Strategy Builder tool to identify dividend stocks according to your criteria.
Key indicators to help you find dividend stocks
There are several other indicators that an investor can apply to further refine their selections and validate the dividend stocks cash flow potential.
Divided Coverage Ratio (DCR)
Dividend Coverage Ratio (DCR) = Earnings per share (EPS) / Dividends per share (DPS)
It is a measure of the number of times a company can pay its current level of dividends to shareholders. A high coverage ratio means that more earnings are available to raise the dividend. When the dividend payout ratio isn’t available this ratio can be used as a substitute.
Earnings per share (EPS)
Earnings per share (EPS) = Net income / Common shares outstanding
For a yield seeking investor, a company’s ability to continue increasing their dividends is paramount. Looking at the historical EPS of a company can help you determine if the company has consistent profitability and operates in a mature industry. If a company’s EPS increases year after year, then the dividend payments may follow.
Debt to Equity Ratio (D/E)
An important factor to consider is the role of debt in relation to dividend paying securities. Most companies will fund their growth with a combination of debt (bonds) and equity. What’s important is finding the right balance between the two and being able to fulfill one’s obligations toward the company creditors.
Debt to Equity Ratio (D/E) = Total Liabilities / Total Shareholders’ Equity
D/E is a measure of the degree to which a company is financing its operations with debt versus equity. The higher the ratio the higher the leverage and the risk of not being able to pay it back. From a dividend strategy standpoint, a lower ratio or one decreasing over time is preferable because a dollar not spent on interest is a dollar that can be paid as a dividend.
The debt-to-equity ratios will vary by industry and comparisons should be made between companies in the same industry.
Once the investor has determined their preferred search criteria and have a short list of stocks, they can go a step further and evaluate their dividend paying stocks using Value or Growth metrics. Some investors will also get a second opinion on their chosen stocks before buying or selling by reading the research reports that their online brokers provide. Finally, investors can look at technical indicators to see how the stock is trending.
Discover all the tools that can help you validate your dividend investment strategy