Just over 20 years ago, I was the subject of an article on dividend investing in Kiplinger's Personal Finance magazine. At the time, I believed that by investing in companies that reliably paid and increased their dividends, I could build up a nest egg that would eventually cover my costs of living from dividends. These days, I still appreciate the power and benefits of a growing dividend stream, but I now plan to use dividends to help maintain my bond ladder, rather than directly spending them in retirement.
The reason for that shift in mindset is simple: As awesome as dividends are, they are never guaranteed payments. When it comes to covering my retirement, I want something with a bit more certainty for the money I need right away. Still, I certainly do still appreciate the dividends I receive. After all, the ability of dividends to potentially grow over time -- and the fact that they get paid based on the health of the business, not the whims of the market -- make dividends a wonderful investing tool.
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How to put the odds of strong dividends in your favor
Over that two-decade-plus span of dividend-focused investing, I learned that while dividends are never guaranteed, there are signs to look for to boost your chances of seeing your dividends remain strong.
First and foremost, it's important to understand how the company earns money, along with what it has going for it that protects its ability to keep earning that money. A dividend is only sustainable if the company can continue to generate the cash it ultimately pays out to its shareholders. By keeping an eye on the drivers behind how it earns its keep, you can often get an early signal as to whether or not its dividend looks like it's at risk, even if its leadership continues to express confidence.
Next, you should also keep an eye on the company's dividend payout ratio, which is a measure of how much it pays out compared to what it earns. This is a case where a "Goldliocks zone" is often preferred. If the company pays out too much of its earnings, it won't have enough left over to invest in its growth or cover for challenges that happen along the way. If it pays out too little, then it's not clear that it's committed to rewarding its shareholders over time.
When it comes to that Goldilocks zone, there's not really a hard-and-fast rule, but a payout ratio between around 25% and about 75% is often reasonable.
In addition, it's important to keep an eye on the company's balance sheet. When things go wrong or financing gets tough for the business, a healthy balance sheet could very well provide the safety net that gets it and its dividend through a temporary rough patch. Two key measures to look at are the company's current ratio and its debt-to-equity ratio.
Its current ratio measures the company's ability to pay the debts it has coming due over the next year from the near term assets (like cash, receivables, and inventory) that it owns. The higher that ratio, the better its chances are of being able to make it through a short-term business hiccup without needing to make major changes to its plans.
Its debt-to-equity ratio looks at what it owes overall compared to what it owns overall. The lower that ratio -- as long as it's zero or above -- the stronger the company's balance sheet is. Think of a debt-to-equity ratio of 2 to 1 as the corporate equivalent of having a $200,000 mortgage on a $300,000 house. This measure is important because even companies have to pay their debts. The better that ratio, the easier it is for a company to come up with an asset to sell to settle its debt if it gets to that point.
Keep your eye on even the good ones
Once you find and buy a company that looks like it might continue to pay and potentially even increase its dividends for a long time, you should still watch that business and see what it actually does over time. Dividends can be an incredibly strong signaling device -- a way to understand what a company's leadership actually thinks, regardless of what that leadership is saying.
This is because most dividends are paid with cold, hard cash. Talk may be cheap, but a regular payment to shareholders that can easily consume millions of dollars certainly is not. By watching what the company does with its dividends -- and how that affects its payout ratio and balance sheet -- you can often get a feel for what its leadership really thinks about its future prospects.
If all goes well, you'll wind up with a portfolio of companies that reliably pay and regularly increase their dividends. If all doesn't go well, you'll at least have a good framework to decide whether it's time to part ways with the company or hold on for the potential of a better future.
Get started now
The path to earning decades of passive income may be a fairly straightforward one, but it's one that by its very nature takes decades to achieve. Make today the day you get started on that path, and get yourself that much closer to your goal.
