by Umar Farooq
If you ever wonder about what are the essential factors that can help you in picking the best dividend paying stock, then solely relying on the higher dividend yield is not going to help you much in your search. Investing in income stocks based on their yield alone can be a huge mistake. In fact, a super-high yield can often be a sign of danger.
When an investor buy a stock, a dividend is reasonable compensation for the financial risk they are taking. The current dividend yield for the S&P 500 is right at 2.08%. Buying a high- dividend stock that pays out, say, 3.5% means that you are being paid 68% more than the index is yielding. Investors often do pay a premium price for stocks that boast high dividend yields but the choice should be made wisely.
Here are the key three metrics that can be used as inputs while putting a dividend-paying stock to the test.
Test No. 1: Predictable revenue
The best dividend stocks have control over their top line. Companies that depend on factors outside of their control for revenue can see their profits evaporate when the markets take a downturn.
Test No. 2: A sustainable payout ratio
The next must-know metric for any dividend stock is its payout ratio. This figure is calculated by dividing the company’s dividend payment per share by its earnings per share. For example, if a company’s annual dividend payment is $1 per share and its earnings are $4 per share, then its payout ratio is 25% ($1/$4).
In general, a low payout ratio suggests that a dividend is sustainable since it provides the company with financial flexibility in case something bad happens. Thus, any stock with a very high payout ratio — say, above 80% — should be approached with caution, even if it passes the first test.
Test No. 3: Strong growth prospects
The best dividend stocks not only sustain their current payouts but can increase them over time, too. That why it’s safe to exclude companies that pass the first two tests but are not expected to grow much over the coming years.
Thus bottom-line is that if you are a value investor, then look for predictable revenue stream, a sustainable payout ratio, and solid growth prospects. Any company that have these features is bound to pass this test of best dividend payment with flying colors.
by Umar Farooq