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November 26, 2019

Three Factors to Investigate Before Buying a Dividend Stock

Dividend paying stocks provide investors a great way to generate income. Periodically, usually every quarter, the company pays a cash dividend to the shareholders. A shareholder can either keep the cash or reinvest it into additional shares of the company. 

Before buying a dividend paying stock, investors should investigate the track record of the company’s dividend and the ability of the company to increase and continue paying the dividend going forward. The short checklist below will help ensure that you are investing in a quality dividend paying stock. 

Consistent Dividend Growth

Quality dividend stocks are consistently increasing the dividend amount paid. Most companies hike the quarterly dividend once a year. This typically occurs soon after the fiscal year financials are reported, but it can happen any time during the year.

When looking for a dividend paying stock you should look for stocks that have a good track record of annual dividend increases. At the very least, look for companies that have increased the dividend every year for at least five years. A ten-year track record of dividend hikes is even better. 

Also, look for companies that did not decrease their dividend during the latest economic downturn. For example, a quality dividend stock did not have a dividend decrease during the 2007-2008 recession. This ensures that the company has the free cash flow generating power to sustain dividend payments even during difficult times.

Dividend Yield In-Line with Historical Averages

The dividend yield is calculated by dividing the annual dividend paid by the price of the stock. For example, if a stock currently trades at $10.00 and the annual dividend is $0.20 per share, then the dividend yield is $0.20 / $10.00, or 2%. Based on this formula, there are two ways that the yield can increase. First, an increase in the annual dividend paid will increase the dividend yield. Second, a decrease in the stock price will also increase the dividend yield.

A dramatic decrease in the stock price can indicate that the company is facing financial or operational issues and that future dividends may be in trouble. One way to tell if a dividend is sustainable is to look at the historical dividend yield over the last five to ten years. If the yield is currently substantially higher than normal, then a second look at the company’s financial health is warranted.

Payout Ratio In-Line with Historical Averages

The payout ratio conveys the percentage of the company’s total net income that is paid out as dividends to the shareholders. Some companies have a high payout ratio that rewards investors while other companies have a low payout ratio and, instead of giving the money to investors, the company uses the money to fuel growth in the business. 

Neither of these uses of net income is incorrect, but as an investor, you need to be aware of the historical payout ratio to ensure the company will be able to sustain the dividend payments. For example, let’s assume a company’s payout ratio was historically 50%, meaning that it paid out 50% of net income as dividends. But then the payout ratio quickly jumps to 95% without the company increasing the dividend. This means that the net income of the company has fallen dramatically. You will need to investigate why the net income has decreased and whether the company is facing significant new challenges that will alter its ability to sustain the current dividend rate going forward.

Of course, there are many other factors to consider before buying a stock. But making sure that the company has consistently increased the dividend and that it can continue to pay the dividend in the future will increase the probability that the investment will continue rewarding you long into the future.