Three Key Questions You Must Ask Yourself Before Purchasing A Dividend Stock

Note this is a guest post from Dan at Stocktrades.ca. Dan is an active Canadian dividend growth investor with whom I share many investing similarities. Hope you enjoy!

-Mike

Dividend investing isn’t exactly the risky business that growth investing is. That being said, a lot of people have the misconception that dividend investing is a bullet-proof route. Although excellent income stocks tend to be resilient during adverse market conditions and often survive the lows of a bear market, you still have to find these survivors.

We’ve been in a bull market for the better part of 8 years now and dividend yields are looking a little bleak these days. The key to a successful income stock investing strategy is learning how to find sustainable dividend stocks that are going to be paying you excellent returns regardless of the market conditions.

I’ve come up with three key questions you need to ask yourself when trying to find the best dividend stocks to purchase for your portfolio. Here they are:

Does the company continually raise its dividend, and do I want them to?

When a company is raising their dividend every year it tells you quite possibly the most important trait you look for when investing in a company for the long haul. It means that revenues are increasing. A couple of companies that have stood the test of time when it comes to increasing dividend payouts are Fortis, Canadian National Railway, CIBC, and Scotiabank. I personally own all of these securities, and do not plan on letting go of them for a very long time.

Now, this isn’t to say a company that doesn’t issue an increase in dividend every year is losing money. There are a lot of ways a company can spend excess capital in a way that benefits shareholders other than issuing a dividend. An example of this would be some sort of acquisition or product development. If you are strictly looking for the passive income an excellent dividend portfolio provides, these companies may not be for you. If you’re looking to give up a little return right now for the potential of greater future growth, you may look to a dividend growth company that is looking to expand its operations.

If you’re looking for some dividend stocks that have consistently rewarded shareholders over the last 5 years, check out DGIRs list of these Canadian All-Star Dividends.

What is their payout ratio?

A lot of investors who are new to the world of dividend stocks may get sucked into drooling over the dividend yield and that yield only. One of the most important calculations you can make when considering adding a company to your portfolio is the dividend payout ratio.

This formula can’t really get much easier, so it would be extremely unwise to look past it. To calculate the payout ratio, simply take the companies dividend payment and divide it by their earnings per share. For example, a company issuing a $1 dividend per year with an EPS of $3 has a payout ratio of 33%.

Why is this ratio important? If a companies earnings per share are less than the dividend being issued, alarm bells should be going off. It’s a little bit of a rob Peter to pay Paul situation. If a company is earning less than they are paying out, they are having to dig that money out from somewhere and accruing debt. This is either a sign that the company is losing money and will inevitably drop the dividend, or in the case of a ratio above say 70%, the dividend will not be going up any time soon. Typically I look for companies with a payout ratio of less than 50%.

Is the price right, and can this stock withstand some hardships?

A lot of people who are devoted to finding the best dividend paying stocks for their portfolio often overlook the most important factor when analyzing a security they would like to purchase. You still must consider the value of the company. A company that is clearly trading over and above its value while issuing a great dividend is still no good to you if the company falls substantially. It’s a good practice to look first at the value of the company based on it’s current share price and make sure it accurately reflects it’s true value before you look at the juicy dividend.

As for the stock withstanding hardships, I decided to lump this question in at the end as it is actually determined by some of the questions I answered above. A company who has continually increased dividends year over year more than likely has the capital to survive a bear market or recession. When I think about this, the first industry that comes to my mind is Canadian Banks. While American banks were slashing dividends left, right, and center during the financial crisis, the Canadian Banks held strong and their dividends were never cut. It’s industries like this that are absolutely crucial to include in your portfolio.

Another good indicator of a company being able to withstand an economic downtown is its payout ratio. Think of it this way, who is going to survive longer without a job; the man who has been putting $1000 away a month for the last 10 years or the man who is living paycheck to paycheck. Companies with a high payout ratio are paying out most of their earnings in the form of a dividend. When an economic downturn hits, these companies cannot handle the blow in the loss of earnings. Whereas a company who’s payout ratio is 30% will have excess capital to keep their boat floating.

Wrapping it all up

Buying dividend stocks isn’t for everyone. You truly have to sit down and think about your overall investment goals before deciding this is the route you wish to take. If dividend stocks is your choice, these three questions should be considered by every investor before deciding to purchase a security. Dividend investing may be “easier” than growth investing due to the fact the volatility isn’t as harsh and the good stocks are often sitting right in front of your face in the form of fast-food chains, banks, utility companies, and any other form massive corporation in Canada today. But that isn’t to say dividend investing is easy. It’s a difficult task and you may be limiting your market returns by executing your plan incorrectly.

If you’re interested in my opinion along with numerous other contributors including Mike, check out our article on the top 15 dividend stocks in Canada. If you’ve finally got your feet wet with a practice account and are finally now looking to take the plunge, I published a Questrade review a while back highlighting one of the best brokers in Canada today. One of which I have been a client of for 7 years now. I hope you liked this article, and happy investing!

Google+