Key dividend metrics investors should know
Before you buy dividend stocks, it's important to know how to evaluate them. These metrics can help you understand how much in dividends to expect, how reliable a dividend might be, and -- most importantly -- how to identify red flags.
Dividend yield
Dividend yield shows the annual dividend as a percentage of the stock price. A $1 annual dividend on a $20 stock yields 5%.
Yield is most useful when compared to a company's own history or peers. An unusually high yield can be a warning sign rather than a bargain, as it may indicate that the company's business and stock price are struggling and that sustaining the payout may become unviable in the near future.
Dividend payout ratio
The dividend payout ratio measures how much of a company’s earnings are paid out as dividends. A lower payout ratio generally indicates a more sustainable dividend and leaves room for growth.
Cash dividend payout ratio
The cash payout ratio shows how much of a company's free cash flow (FCF) is distributed as dividends. Free cash flow is the cash left over after a business covers its operating costs and capital spending.
Because dividends are paid in cash rather than accounting profits, this ratio is often a better indicator of dividend safety than earnings alone. A lower cash payout ratio means the company has more room to fund its dividend, invest in growth, and weather downturns. A high ratio can signal that the dividend may be harder to sustain.
Earnings per share (EPS) growth
Earnings per share (EPS) growth measures how much a company's profit per share increases over time. Companies with consistent EPS growth are more likely to maintain and raise dividends, since growing profits fuel higher payouts. Over the long run, dividend growth almost always follows earnings growth, making EPS growth a key signal of dividend quality.
FCF growth
Earnings per share are important for dividend health, but in most cases, dividends are paid from a company's free cash flow. Accounting for earnings per share excludes capital expenditures, so looking only at earnings doesn't provide a full picture of the business's health.
Meanwhile, free cash flow is calculated by subtracting capital expenditures from the business's operating cash flow. So looking at FCF growth provides valuable insight into the sustainability of a company's dividend payout and how much room there is for payout growth.
Total return
Total return combines dividends and share-price gains. A stock that pays a 3% dividend and grows 7% annually delivers a 10% total return.
Why high yield isn't everything
Many new investors are drawn to the highest dividend yields, and that's often a mistake. A rising yield can result from a falling stock price, signaling that investors expect the dividend to be cut. This is known as a dividend yield trap.
Here are some steps you can take to avoid falling for a yield trap:
- Don't buy stocks based on yield alone.
- Check payout ratios and free cash flow.
- Look for a history of dividend growth.
- Review the balance sheet and debt levels.
- Understand the company's business risks.
Sadly, a yield that looks too good to be true often is. It's better to buy a dividend stock with a rock-solid lower yield than to chase a high yield that may prove illusory.
Focusing on dividend growth -- a company's history and ability to raise its dividend -- often proves more profitable.
Examples of dividend stocks
Here are some well-known companies with a long history of paying dividends, along with their dividend yields at recent stock prices and the per-share amount of each dividend.
