What adds value to an equity share, in addition to the increase in its price, is the dividend payout. Steady stocks with a history of regular dividend payments are attractive investments for retirees and those seeking a steady source of income. A smartly chosen portfolio of dividend-paying stocks makes for a great income source in the long term. Studies have revealed a positive correlation between consistently high dividend yield and the future growth potential of stocks. Taxation is levied on dividends, according to standard or reduced rates.
While not all high growth stocks may be paying dividends (Berkshire Hathaway being a case in point), the ones that do, make for ideal investments. Investors looking for a long term (10 year or more) investment horizon, should opt for these stocks. These investments prove to be productive assets during bear markets, ensuring a steady income stream.
A thorough analysis of the stock’s current relevant fundamentals, its history, the future potential of the business in its market domain, and the ability of its management are some of the factors that need to be taken into consideration. In what follows, we provide a succinct guide, that will identify the exact factors to consider and help in developing your personal investment process.
Choosing Dividend-Paying Stocks
As much as 80% of the S&P 500 stocks pay dividends, providing a substantial pool to choose from. We have extracted the best stock-picking advice from the world’s leading investment professionals to provide pointers that will help you choose the right equity options.
Long History of Consistent Payments
Companies with known dividend-paying history spanning decades, with a steadily increasing yield percentage, make for good investments. An example is Procter & Gamble (NYSE: PG), that is backed up by two solid decades of growing dividend payout record. Another example is PepsiCo Inc. (NYSE: PEP), with two decades of consistently-rising dividend payment history. This doesn’t mean that stocks that have only recently started paying out dividends should be ignored, but a company that has a proven history makes for a safer bet. The ability to pay out dividends to shareholders on a regular basis, indicates the sound financial health of a company.
Good Dividend Yield
Yield percentage is obtained by dividing the annual dividend yield offered per share, by the price per share. In short, it quantifies the degree of returns per dollar invested in a share. For example, if the annual dividend yield paid out by a company is USD 1 and its price happens to be USD 20, then the yield percentage is 5%. Most companies provide 2% to 5% yield, making for decent investments. A value higher than 5% does not necessarily indicate a good stock, as that amount of payout may prove to be unsustainable in the long run and the dividend yield may in fact decrease in the future. Look for businesses that have sustained or gradually increased their yield over the years.
A Decent Payout Ratio (Preferably Less Than 60%)
The payout ratio defines the quantum of earnings paid out as dividends by a company. It is obtained by dividing the dividends per share, by the earnings per share of the company. Generally, if the payout ratio is too high (above 60%), it may turn out to be unsustainable in the future. A payout ratio that’s less than 60%, indicates that the company may be using the remaining shares of its earnings for share buybacks or reinvestment in its own business activities; this being a good sign.
High Earnings Per Share (EPS)
A high earnings per share value, that has consistently grown over a decade, indicates that the business has been steadily growing in profitability. Ergo, a history of progressively rising EPS marks out a growing business and makes for a good investment.
Strong Free Cash Flow
The ability of any public-listed business to expand its operations, pay out dividends, engage in share buybacks, and acquire new assets depends upon the availability of ready cash. This free cash flow is the amount of money at a company’s disposal. It is calculated by subtracting capital expenditures from the operation cash flow. Companies with strong positive cash flows are most well-positioned to pay out dividends in the future and therefore, make for excellent choices.
Ability to Buy Back Stock
Another feature that you should look out for is a history of share buybacks by the company, from shareholders. When shares are bought back, the number of shares available in the market reduces, automatically increasing the earnings per share, besides benefiting the investors from whom the shares are bought. Moreover, it increases the value of existing stock for investors. Therefore, it is beneficial to go for a company that has opted for share buybacks in the past, as it is more likely to do the same, in the future.
Predictable Earnings and Steady Demand
Stocks from sectors like utilities, that can provide predictable earnings over the years, with high demand for their products in domestic, as well as international markets, make for ideal investment targets for the long term. The high demand guarantees consistent sales, which in turn indicates a positive cash flow, leading to dividend-paying ability.
High Cash Balance
High retained cash balance ensures that the company has enough balance to fund future dividend payouts. High liquidity is a strong asset, that boosts the stock’s value.
Besides all the above factors, the fact that a company owes less and has low expenses in terms of interest payments, makes it buoyant enough to pursue new projects and take risks, which is good for the growth of the stock, in the long term.
Strong Fundamentals and Stock Price Stability
Very high volatility in stock price indicates erratic financial performance. Ergo, price stability over the years is an important factor to consider, when evaluating a stock. Other than all these features, look for companies with a capable management and strong financial fundamentals, indicated by high quarter-on-quarter revenues, high return on investment (ROI), low P/E, and low P/B ratio.
Through dividend reinvestment programs (DRIPs), a company offers you the option of buying more shares through your dividends, instead of getting paid in cash. This is an added advantage of opting for such stocks.
Always think long term, is a dictum that has often worked in favor of most successful investors and you need not be an exception. Thinking of a stock as buying a quantum of ownership in a business, helps in developing the appetite to stay invested for the long term. Base your decisions on financial fundamentals, instead of the latest speculations. To sum up, look for positive cash flow, predictable earnings, low debt, high cash balance, growth potential, and history, when choosing income-generating dividend stocks.