Due to historically low interest rates, many investors are now focusing on investing in dividend paying stocks. In times of volatility, it is somewhat reassuring to know that you will still receive your regular dividend even if stock markets are uncertain.
Let’s take a closer look at dividend stocks and the key metrics to consider when deciding to buy them.
Most investors will initially look at the dividend yield which is the ratio of the annual dividend paid divided by the current share price and is represented as a percentage. 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.
Given that the change in the stock price influences the dividend yield, it remains important to verify the dividend amount paid and the evolution of the dividend.
Dividend Payout Ratio
Another ratio to consider is the dividend payout ratio which is calculated as the dividends per share (DPS) divided by the 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 (capital expenditures, paying down debt, buying back shares or added to the retained earnings).
The payout ratio varies from one industry to another or if the company is in the growth or mature phase of its life cycle. All else being equal, an investor would prefer payout ratio which provides the company with the flexibility to invest in growth projects and grow its dividends over time or even a buffer in the event of a decline in profits.
Earnings per Share
In the previous section, we discussed the importance of the payout ratio. For mature companies in mature industries that ratio will generally be stable, but that is not always the case for all dividend-paying stocks. Most stock filters will not track the historical payout ratio, but one can still determine that ratio by looking up the historical earnings per share of a company. EPS is the company’s profit divided by the number of outstanding shares of its common stock. The higher the EPS, the more profitable the company is considered.
For certain companies, the EPS can be extremely volatile and the dividend payout can reach 100% or even higher. In such cases, the dividend is at risk of being cut. By researching the historical EPS over a longer period, one can determine the reliability of the company’s earnings and hence the safety of its dividend.
Net Debt to EBITDA Ratio
This ratio is a measurement of leverage, calculated as total debt minus cash & equivalents divided by EBITDA (earnings before interest, taxes, depreciation and amortization) and is also readily provided by companies. A lower ratio compared to other companies within the same industry is preferable. A high and increasing ratio over time could indicate a deterioration of the company’s prospects and the risk of an eventual dividend cut.
As you can see, there are numerous metrics that can be used in combination to evaluate if a dividend-paying stock is the right investment for you. The ones mentioned above are a good starting point and remember that if the dividend yield is too good to be true, there is most likely a reason why.
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