Dividends can be a great source of income when used the right way. In fact, with time and consistency, they can even be a vital part of someone's retirement income, possibly accounting for thousands of dollars monthly.
The first thing most investors tend to focus on is dividend yields. After all, who wouldn't prefer a 10% yield over a 3% yield? But yields can be deceiving. Dividend yields are determined by dividing a company's annual dividend payout by its stock price. If a company pays out $3 per share annually and the share price is $100, the yield is 3%. If the stock price drops to $30 a share (for whatever reason), the yield is now 10%. The yield is suddenly higher, but it's only because of a sharp price drop. So investors shouldn't rely just on yield to decide a dividend stock's worthiness.
To really get the most from dividend investing and avoid falling into dividend traps, here are three metrics dividend investors should have a firm understanding of as they analyze dividend stocks.
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1. Payout ratio
A metric that has a lot more to say about the strength of a company and its ability to consistently pay dividends as well as periodically increase the dividend is something called the payout ratio. The payout ratio is the percentage of a company's overall earnings that is going to fund the dividend. If a company generates an annual EPS of $12 and pays a dividend of $3 per share, its payout ratio would be 25%. the ratio changes based on the EPS in any given quarter (or year) and can vary based on earnings cycles and time of year.
When a company has been increasing its dividends for years but its earnings aren't keeping up, the ratio starts to climb. For most stocks, a payout ratio above 100% for more than a quarter is a serious red flag because a company paying out more than it's making won't be able to sustain that level without going into serious debt. You also don't want a company that pays out too much of its earnings because that's less money the company should use to keep reinvesting in itself to keep growing.
There's no right or wrong payout ratio for companies, but generally speaking, a ratio between 30% to 60% is considered "sustainable." For some real estate investment trusts (REITs) the ratio can get as high as 80% and still be sustainable. When the ratio climbs above those sustainable rates for an extended period, pay close attention to the company's finances as something isn't right.
2. Dividend growth rate
Most investors try to focus on the future potential of a company and not making decisions solely based on current metrics. For dividend investors, a company's current dividend yield is important, but a dividend growth rate (how much the dividend is rising each year) can be even more important. Two companies can have a 4% dividend yield, but if one company is increasing its dividend annually, it's the more appealing option.
Dividend Aristocrats are stocks in the S&P 500 that have increased their dividend payouts annually for at least 25 consecutive years. Dividend Kings have increased their payouts for at least 50 consecutive years. Focus your dividend stock research on companies that have managed to keep their dividend going and rising. The ability to do so shows the company is generating excess cash flow regardless of economic conditions or market downturns.
3. Cash flow
Speaking of cash flow, a company's cash flow is another important metric that is often overlooked. In any business, it's vital to have more money coming in than going out; otherwise, the business isn't sustainable and is likely headed down the wrong path. For many companies, paying out dividends is one of the largest causes of money flowing outside the company.
As a dividend investor, you want your company to have a strong cash flow because it shows the company's ability to pay out dividends (and keep paying them out). You also want it to have cash on hand to reinvest back into the company for growth or take advantage of other opportunities. If a company has weak cash flow, it likely won't be increasing its dividends, and the chance of it reducing or suspending the dividend increases. Strong cash flow provides flexibility for the company.
