Dividend is one of the ways companies reward their shareholders. Holders of dividend-paying stocks receive periodic cash payments issued by the companies who issue these stocks.
A portfolio of robust dividend-paying stocks is one of the best ways to accumulate wealth, generate passive income and provide protection from inflation. However, it’s not always easy to find quality dividend-paying companies.
There are 8 key factors investors should consider when finding the best dividend-paying stocks.
KEY TAKEAWAYS
- Assess the prospect of the business.
- Pay attention to the stock valuation.
- Look at the broader industry trend and macro conditions.
- Understand the dividend payment consistency and sustainability of a company.
- Don’t put all eggs in one basket.
Business fundamentals
First thing to consider when deciding to invest in anything, is to understand what the investment actually is, its current conditions as well as future prospects.
When picking a dividend-paying stock, it is crucial to look into the fundamentals of the underlying business. What does it do? Are they profitable? How does it generate income? What’s the business growth trajectory? What is the prospect of the industry the company operates in? How is the company managed? Answers to these questions could indicate whether a business is solid.
PEG ratio
A PEG ratio is a metric used to evaluate whether a stock is over or undervalued. It’s calculated by dividing a company’s P/E (price to earnings) ratio by its trailing annual EGR (earnings per share growth rate).
For example, Apple (Apple Inc) has a current P/E ratio of 25.68, its current trailing twelve months EPS growth is around 38% year over year. Therefore, Apple’s current PEG ratio is 25.68 ÷ 38* = 0.67 (*for the calculation, always multiply the EPS growth rate by 100).
By definition, a stock with PEG below 1 is considered undervalued, 1 being fairly valued, and overvalued if the PEG is over 1.
Dividend yield
Dividend yield is a percentage number calculated by dividing a stock’s annual dividend per share by its current stock price. A 1% dividend yield means the company will pay back 1% of shareholders’ stock holdings as cash rewards over a year. It’s a good measurement of how much return is generated by the shareholders’ investments.
For investors looking for income generation, 2% to 6% is usually considered a good dividend yield. However, having a higher dividend yield alone doesn’t necessarily mean a good stock to invest in. There are many more factors to consider.
Dividend payment history
Investors looking for consistent income generation should pay attention to dividend history. It’s the track record of how a company pays dividends back to investors.
Dividend payment frequency, payment consistency and growth trend are good signals to show how reliable a company is as a dividend payer.
Good examples of reliable dividend-paying stocks can be found on S&P 500 Dividend Aristocrats, a stock market index composed of companies in the S&P 500 index that have increased their dividends in each of the past 25 years.
Dividend payout ratio
The dividend payout ratio is the percentage of the company’s net income paid out to shareholders as dividends. A dividend payout ratio of 80% means the company pays back 80% of its net profit back to its shareholders through dividends, and keeps 20%.
This is an indicator that shows how comfortably a company can afford to pay its current dividends. If a company’s dividend payout ratio is over 100%, it means the company is paying out more than it earns, which is likely to be unsustainable in the long run.
An attractive and comfortable dividend payout ratio is usually around the 35% to 55% range.
Debt to equity ratio
The debt to equity ratio shows how much a company’s debt is in relation to its shareholder equity. It’s a metric that measures a company’s ability to pay off all debts by selling shareholders equity in the event of a business downturn.
A high debt to equity ratio means the company is highly leveraged in order to operate its business. This is usually a sign of potential risk.
What is a good debt to equity ratio? Although there is no official definition, a debt to equity ratio of 2 to 2.5 is generally considered good.
Total return
Total return is a good measurement of a stock’s overall performance. It’s the total return rate of a stock including capital gains, dividends and interests over a period of time, typically a year.
It’s important to assess the overall performance strength of a dividend-paying stock. As a company may keep up with the pace of dividend payouts while its share price declines significantly, which may incur an overall loss to the shareholders.
Diversification
Dividend stock investors are usually looking for reliable, steady passive incomes with minimal risks. A diversified stock portfolio usually provides protection from unforeseen risks, and keeps the passive income stream constant.
Consider investing in multiple quality dividend-paying stocks from different industry sectors to minimize risk exposure.