Wednesday, September 17, 2014

Three Questions That Every Dividend Investor Should Ask Themselves

Investors purchase dividend stocks in order to generate a reliable source of cash that would help them pay for their expenses in retirement. In theory, this is a great idea. However, certain little details could seriously derail the investor’s success. In order to ensure that they will be able to hit their investment goals, dividend investors should ask themselves the following three questions:

1) Is the dividend Safe?

Many dividend investors who are just getting started tend to focus on companies with the highest dividend yields. Noone can blame them for this, as it is every investors goal to maximize their investment returns. Investing purely for dividend yield however, could easily backfire without some basic research. The company with a mouth-watering 8% yield today could end up cutting or completely eliminating the distribution, which could lead to loss in dividend income and huge losses. This could derail anyone’s retirement plan. Investors should instead attempt to understand how the company makes money, and should also calculate whether the dividend is adequately covered. I typically look for a margin of safety in dividend coverage. This means that I typically look for a dividend payout ratio of 60% or less, which means that earnings are roughly 67% higher than the dividend paid. This payout ratio fluctuates from year to year, which is why it is important to look at it for the past decade, in order to gauge the sustainability of dividend payment. While there are no guarantees that the dividend would be paid out, even if it is adequately covered, a sustainable distribution increases the odds that the investor would be able to enjoy an uninterrupted stream of dividends.
For certain entities such as Master Limited Partnerships or Real Estate Investment Trusts, I tend to prefer a stable or declining ratio of distributions to cash flow from operations ( FFO or DCF).

2) Will the dividend grow?

Inflation is the largest enemy of the retired investor. Prices have been on a slow but steady increase over the past century. Even at a modest 3% annual inflation, prices of goods and services will double in 24 years. As a result, investors need to have a stream of income that will increase sufficiently to cover the effects of general price increases. Dividend growth stocks are a perfect investment vehicle for such endeavors. In my portfolio I purchase stocks which have exhibited a strong corporate culture, backed by real profits, which has resulted in long streaks of consecutive dividend increases. Newton’s law that a body in motion will keep being in motion is in full force with dividend growth investing. Just because a company has raised distributions for 20, 30, 40+ years does not mean it is a good buy at the moment however. In general, companies can only afford to grow dividends if they manage to increase profits over time. Investors should thoroughly analyze the company by reading annual reports, analyst reports and keeping up-to-date on any company developments. This is in order to determine whether the possibility of future dividend hikes is higher than average.

3) Will the company deliver solid total returns?

Many investors seem mesmerized only by dividends, do not do much due diligence on growth, and tend to forget about capital gains in the process. This could be costly to your financial well-being. Historically dividends have accounted for about 40% of total returns over the past 80 years. The remainder has been achieved through capital appreciation in stocks. In general, dividend growth companies with moderate current yields in the 2%- 4% range with payouts below 60% stand a very good chance of delivering solid capital gains over time. This is in addition to the rising dividend payment. While, capital gains are not as reliable for retirees as dividend payments, they do ensure that over time the purchasing power of the investor’s capital is maintained and increased. If all else is true, a company yielding 2% - 4% today that also manages to grow earnings and dividends at a healthy clip, should be able to increase in value over time. This again ensures that my capital maintains purchasing power as well. I do not plan on selling most of the holdings I own, however I do want to see increases in networth over time.

Relevant Articles:

Dividend Investing for Financial Independence
Investors Should Look for Organic Dividend Growth
Dollar Cost Averaging Versus Lump Sum Investing
When to sell your dividend stocks?
How to monitor your dividend investments

12 comments:

  1. The majority of capital gains come from buying at the right price. Excellent post.

    ReplyDelete
  2. DGI,
    Do you favor one over the other 2 or do you weight them all equally when screening?
    Thanks,
    DFG

    ReplyDelete
  3. DGI,

    Couldn't agree more. If the dividend isn't safe and/or growing, then the odds are good that you won't see the solid total returns in your third point.

    Best regards!

    ReplyDelete
  4. "This means that I typically look for a dividend payout ratio of 60% or less, which means that earnings are roughly 67% higher than the dividend paid." Can you explain the math on this to me? Excuse my ignorance.

    ReplyDelete
    Replies
    1. The calculation is relatively straightforward: Earnings (represented by 100%)/Earnings paid as dividends (60% or less). 100/60 equals coverage of 1.67 times dividends, or 67% in excess of dividends paid.

      DGI - As DM stated so clearly, when you find dividends that aren't safe or growing, odds are the underlying business will not likely generate the returns desired.

      Delete
  5. Great post! Very good questions to consider when purchasing dividend paying stocks.

    ReplyDelete
  6. Great post, agreed! #2 is critical, otherwise, might as well index invest.
    Mark

    ReplyDelete
  7. Totally agree. Dividend growth is the key for long term investor. Entry price is also very important to guarantee total returns.

    MU

    ReplyDelete
  8. Agreed these 3 questions are very important to a dividend growth strategy.

    Were you aware that Josh Peters at Morningstar DividendInvestor calls these 3 same exact questions the "Dividend Drill" (since at least 2007). Is the dividend safe? Will it grow? What is the return?

    ReplyDelete
  9. Very good principles to have in DGI. Looking for just high yield can be devastating, if the overall growth prospect of a solid company is not there. Diversification is key in a portfolio meant for retirement income. Thanks for the post!

    ReplyDelete
  10. Agreed! Steady and reliable dividend growth is the way to go. When evaluating two companies within the same industry I also like to compare EPS, P/E and how invested the big institutional players are in those companies. The trend I find is that good, stable companies are usually the ones picked up by big financial companies and funds.

    ReplyDelete

Questions or comments? You can reach out to me at my website address name at gmail dot com.

Popular Posts