Dividend stocks offer investors a little something extra. You not only get an ownership interest in the company, but you also receive a payment each quarter to further incentivize you to buy shares.
That sounds great -- and it can be -- but not all dividend-paying stocks are right for your portfolio. You want a company that has enough free cash flow to pay a dividend, while also having the money needed to invest in growth. You should also look for a company that has limited or no debt, and keep an eye on growth.
When looking for a dividend stock you want to consider long-term stability. Image source: Getty Images.
Watch out for traps
It's important to remember that while dividends can be great, they can also be a bit of a trap. Sometimes companies pay a dividend when they really would be better off investing that money back into the company.
That can be tricky to see sometimes. A company may look strong in the short term, and it's not always easy to see the negatives in its future. A recent example of that would be Frontier Communications (FTR +0.00%), a company that paid a dividend (and a strong one at that) despite going heavily into debt in April 2016 while spending $10.54 billion to buy millions of cable, internet, and phone customers in California, Texas, and Florida.
At the time, the move seemed like a good one. It doubled the size of the company, which should provide opportunities to lower expenses and allow for more investment. What Frontier misjudged, however, was that consumer cord-cutting would start to accelerate quickly and tighten the revenue streams of its holdings.
Even if the purchase had worked, Frontier should have suspended its dividend much sooner. It was taking on billions of dollars of debt and had expenses related to integrating the new customers. It was paying money to shareholders that it did not have, probably because not doing so would cause its stock price to fall. In reality, nothing could have stopped that from happening, and the company wasted money that could have been better used to service its debt.
This is a somewhat extreme example, but in a broad sense, it highlights the things an investor should look for in a potential dividend stock. You should evaluate dividend stocks using three criteria:
- Is the company healthy now? What does its balance sheet look like? Is it comfortably profitable with limited or no debt?
- Is the company investing in the short term? Has the company been spending the money it needs for sustainable short-term growth? Is it reasonably adding new locations or expanding?
- What are the long-term headwinds? This is the hardest thing to know as an investor. To evaluate whether a company is preparing for the long term, it helps to listen to its earnings calls, look at its capital allocation, and investigate its research and development spending.
It's generally reasonable to expect that a company that has been well run for a long time will be better prepared to deal with longer-term issues. And, in a very broad sense, a company with more diverse sources of revenue that operates in multiple markets will be better prepared for longer-range shifts in its operating environment.
Perfect for a retirement portfolio
The strongest dividend stocks are companies that essentially have more cash than they know what to do with. You want to avoid companies that pay dividends to prop up their stock prices. Look for stocks that are investing heavily in growth and expansion, while also keeping debt down or non-existent.
Those companies essentially have extra money to share with shareholders. That's a have-your-cake-and-eat-it-too scenario. You get to own a share in a company with sound financials that you believe in over the long-term, and you get paid to own it.
