Dividend stocks are a popular investment strategy, and rightly so. Who doesn't like getting paid passive income -- dividend checks that keep coming, paying your bills, or being reinvested to make that snowball just a tad bigger? But not all dividend stocks are created equal; knowing the difference between the good and bad apples can save your portfolio some pain.
There isn't one rule that applies to all dividend stocks, but some key components make a company a safe dividend investment. Know and use these tips, and you'll build a portfolio that rewards you with reliable and growing dividends.
1. Follow the payout ratio
First, understand what dividends are and where they come from. A company paying a dividend means the business sends you a portion of its profits. Dividends aren't accounting voodoo; they are cash payments. In other words, a company can't fake a dividend; it must have the cash to pay it.
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A company's dividend payout ratio is like taking the pulse of the dividend; it tells you exactly how much of a company's profits are going toward the payout, which means how easily the company can afford it. A company with a 90% payout ratio sends almost all of its profits to shareholders. That might sound great, but it leaves virtually no money to invest back into the business or no breathing room if the company's profits fall. To give an idea, I like to see a dividend payout ratio under 70%.
You can also look at the dividend payout ratio over time to see whether it's trending higher or lower. If it keeps rising, the dividend grows faster than the company's profits, which can't be sustained forever. The payout ratio can tell you about the dividend's health, so it's a great starting point.
2. A growing company pays an increasing dividend
It might seem obvious, but a good dividend stock is a company that steadily grows its top and bottom lines. This isn't always easy; there are just 65 Dividend Aristocrats in the S&P 500, companies that have raised their dividends annually for 25 consecutive years or more.
Growth doesn't necessarily have to be exciting for a dividend stock, but it must be somewhat consistent. Think of companies like Coca-Cola, Procter & Gamble, and PepsiCo. These Dividend Aristocrats all sell products that people buy regardless of what the economy is doing.
There are multiple ways to increase profits for dividends. A business can grow revenue, which will trickle to the bottom line if its profit margin and operating costs stay the same. On the other hand, a company can repurchase shares to reduce its total dividend expense. That would let a company raise the dividend more because lowering the share count will slow the payout ratio's rise.
The best dividend stocks are companies that can grow and produce enough profits to raise dividends and repurchase their shares simultaneously. Again, it's not easy; that's why so few Dividend Aristocrats exist. History doesn't guarantee future outcomes, but a strong track record of revenue and earnings growth is a good signal for a dividend stock's future.
3. Mind the balance sheet
Think of a company's balance sheet as a safety net; it can help fund operating expenses if it suffers an unexpected downturn. It can give management the financial firepower to invest in new growth ideas or make acquisitions. Good management teams will typically protect their balance sheet; a company that runs into balance sheet problems could cut the dividend to free up profits to pay down debt.
How do you know if a balance sheet is in trouble? One metric is the debt-to-EBITDA ratio, which measures a company's debt against its core profits before factoring in interest, taxes, or noncash accounting adjustments. There isn't a hard rule for what makes a good ratio, but I like to see most companies operate at a debt-to-EBITDA ratio of 3 or less.
You can look at a company's balance sheet in its annual report or quarterly earnings for a given year, which lets you see whether the company is taking on debt over time. If so, ask yourself why. Sometimes debt can be a good thing, but if a company borrows money to pay a dividend or repurchase shares, it could be a warning sign that management is spending above its means. That can come back to hurt investors over the long term.
