Income investing should be one of those activities that allow an investor to sleep at night. A steady return of cash via dividends is a great way to pay for retirement, college education costs, or any other periodic payment. Dividend stocks and fixed income investments are great ways to generate these returns.
But going with an income stock requires one to remember one general rule: common stock dividends are the last in line to get paid. So, when the company runs into financial difficulties, dividends are often the first expenditure to get put on hold. So, it's important to pick the right companies that manage themselves well enough to maintain and/or (even better) improve their dividends each year.
Here are three other tips to remember when navigating the investment seas of income stocks.
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1. If it looks too good to be true, it probably is
This is the No. 1 thing to keep in mind when looking at dividend stocks. Whenever you look at a dividend stock with a dividend yield percentage that is much higher than its peers, the market is telling you that there is some risk to that dividend. As a general rule, the higher the expected return, the riskier it is. That is why the debt of distressed retailers results in the stock trading at double-digit yields, while many Treasuries are yielding at less than 1% these days.
To make sure you aren't falling for a trap, you should compare the dividend on the stock you are analyzing versus its peers. If the peer group yields around 4% and the stock you are looking at yields 8%, that's a big red flag. A classic example of this was Wells Fargo (WFC -0.56%), which traded at a 7.5% dividend yield last month when peers like JPMorgan Chase (JPM 0.49%) had dividend yields around 3% or 4%. When Wells announced its second-quarter earnings, it cut the dividend from $0.51 to $0.10 per share. What happened to Wells Fargo this year was typical of a company generating a too-good-to-be-true dividend yield.
2. Payout ratios can help indicate which stocks are at risk
How can you tell if a dividend might be at risk? The easiest way is to look at the stock's payout ratio, which is the annual dividend per share divided by earnings per share. This number gives you an idea of how much breathing room the company has. Good companies try not to overtax their free cash flow rates by dedicating too much toward the dividend. This leaves them funds to put toward R&D, acquisitions, or other investments that can help them fund their future dividends.
As an example, let's look at the aforementioned JPMorgan Chase. JPMorgan pays a quarterly dividend of $0.90 per share, so its annual dividend comes out to $3.60 a share (four quarterly payments). The analyst consensus EPS estimate for JPMorgan in 2020 is $5.73 a share, so the payout ratio is $3.60 divided by $5.73, or about 63%. This is payout rate is par for the course for a mature company like JPMorgan.
A good rule of thumb is that when payout ratios for non-REITs start to reach 75% and higher and the company keeps paying out that higher ratio over several quarters, the dividend will be tough to maintain. If you can get your hands on the annual EPS estimate, make a quick calculation to make sure you aren't buying a value trap stock that can't generate enough free cash to fund its dividends easily.
If the stock in question is a real estate investment trust (REIT), it will invariably have a high payout ratio, because earnings per share for a REIT isn't the best approximation of cash flow, funds from operations (FFO) is. REITs on the other hand are required to pay out most of their earnings as dividends, so 85% payout ratios (looking at FFO per share, not EPS) are normal.
3. Keep a close eye on earnings trends
Past performance is not necessarily indicative of future performance. This is one of the key things to keep in mind when looking for dividend stocks. Often, a high dividend yield is a result of a company that is in decline or about to go through a rough patch. Because of how the yield is calculated, a falling stock price can artificially increase the yield percentage rate. The reverse is also true, where a stock increasing in value can make what would otherwise be a good dividend yield appear smaller.
If the stock has been steadily declining in price, start to worry about the safety of the dividend. This is especially true if the industry that company operates in is having a tough time. This year, the entire retail sector and most of the retail REITs have been clobbered by closures, social distancing, and uncertainty. In this sort of situation, you can't simply look at the dividend yield and extrapolate that return going forward. If the company's peers are cutting dividends, chances are the stock you are looking at may have to as well.
Know the risks before you invest
Dividend stocks, along with fixed-income stocks, are a great way to generate the personal income you will need in retirement. However, they are a little less secure than bonds are. Investors who spend the time up front to determine whether the dividend yield of a company is at risk are less likely to be blindsided by a dividend cut.
