When investing, your capital is at risk and you may get back less than invested. Past performance doesn’t guarantee future results.
What makes a good dividend stock?
Investing in stocks to earn a return through dividends can be an excellent way to generate passive income and build wealth - and it requires relatively little upkeep.
Characteristics of a good dividend stock
You need to get familiar with the important characteristics that make a good dividend-paying stock. This is the kind of stock that you’d want to keep in your portfolio year after year. Specifically, these characteristics fit into two camps:
Qualitative - Looking at the business itself and what it does
Quantitative - Analysing the numbers
Qualitative - Looking at the business itself and what it does
Quantitative - Analysing the numbers
Big ideas
- The qualitative features of a company are what it does, the industry it is in, how long it has existed etc. We give the example of Warren Buffett’s favourite Coca-Cola.
- Quantitative measures such as the price-to-earnings ratio are formulas used to judge the size and health of a dividend.
Qualitative characteristics
The tactic of the stock brokers led by Leonardo Di Caprio in the Wolf of Wall Street was to first offer their clients a blue-chip stock to gain their trust before flipping them into pink sheets and penny stocks that earn very high commissions.
The first qualitative characteristic you should look for is that the company should not be the kind of “exciting opportunity” that stockbrokers would call you about! The company must be stable. If investors make money in exciting companies, it will be through the growth in the share price - not through dividends.
With a good dividend stock portfolio, you shouldn’t need to be constantly following the market with sophisticated techniques. You are a long-term passive shareholder directly benefiting from the profitability of a company. Dividend investors are generally looking to avoid risk and excessive stock price fluctuations so that they can comfortably grow their portfolio incrementally over time.
Understanding a company's stability and the industries, it operates in doesn’t have to take forever. A combination of research and common sense is needed. You need to get to know the company and what it does and decide whether it is a business that has good long-term prospects.
With a good dividend stock portfolio, you shouldn’t need to be constantly following the market with sophisticated techniques. You are a long-term passive shareholder directly benefiting from the profitability of a company. Dividend investors are generally looking to avoid risk and excessive stock price fluctuations so that they can comfortably grow their portfolio incrementally over time.
Understanding a company's stability and the industries, it operates in doesn’t have to take forever. A combination of research and common sense is needed. You need to get to know the company and what it does and decide whether it is a business that has good long-term prospects.
Watch our video
Warren Buffett’s stock with a good dividend
Warren Buffett has held shares of Coca-Cola since the late 1980s; the company accounts for about 8.5% of Berkshire Hathaway's portfolio at the time of writing.
Source: Trading 212 appSome Coca-Cola stats
- 79,000 employees - this is a huge company.
- It’s in the consumer / non-cyclical sector - which is generally seen as defensive in a portfolio.
- It’s in the beverage industry - which is a stable industry to be in, although not all beverage companies are stable.
- Operates on all continents.
- Owns major brands, Coca-Cola obviously, Sprite, Fanta but also Costa coffee, Vitamin Water, Minute Maid etc.
- Operates in 200 countries.
To further your knowledge of a company, you can join the quarterly conference call that management holds after releasing quarterly earnings. Here you can hear the management discuss the company and hear analysts asking about what they think is currently important for the business.
It really doesn’t need to take more than a few hours to investigate a potentially good dividend stock to buy, which you might end up being invested in for years - even decades!
It really doesn’t need to take more than a few hours to investigate a potentially good dividend stock to buy, which you might end up being invested in for years - even decades!
Quantitative characteristics
Here are 5 quantitative techniques to help decide what is a good dividend stock.
1. Dividend yield
This is probably the most basic technique for filtering your stock choices. The dividend yield is how much return in dividends you will get from your investment in a particular stock.
FORMULA
Dividend yield = (Dividend per share / Stock price) x 100
If the share price is $100, and it pays a dividend of $5 a year then the dividend yield is 5%.
Warning
When dividend investing, one of the things to be avoided is what is called a "dividend trap" stock. These stocks pay a high dividend and look like great investments if you’re only looking at the dividend yield. That high dividend acts like blinkers over people's eyes - they see the big returns and miss some big underlying issues with the company.
As a general rule, It's not advisable to apply a single criterion. Try to include various techniques and give yourself the best chance at filtering out the bad stocks.
2. Dividend growth rate
Stable companies are to be cherished but one thing that should not be stable is the dividend payout. The best scenario is when companies raise it gradually over time. That way the investor earns more and has a better chance of keeping pace with inflation.
A company's history of past dividend payments is publicly available information and can easily be found online.
Payout history of Coca-Cola
Source: Trading 212. Past performance doesn’t guarantee future results.Past payouts are not a prediction of the future but a good dividend stock history does demonstrate that the company is capable of doing what you need it to do.
3. Payout ratio
Since investing is all about holding for the long term, you want to make sure the stock you choose can keep up its payments. One of the ways to do that is to check the payout ratio, which is what percentage of the company's profits are paid out in dividends.
FORMULA
Dividend payout ratio = Dividends paid / Net Income
A payout ratio in the 40-50% range means more than half of the company's profit is reinvested into growing the company.
Generally speaking, a lower payout ratio is more sustainable. It can also mean a lower dividend yield. This is a balance that you must strike when selecting your stocks.
Generally speaking, a lower payout ratio is more sustainable. It can also mean a lower dividend yield. This is a balance that you must strike when selecting your stocks.
4. Debt-to-profit
Another potential threat to the company’s stability is if it has a lot of debt. A company with too much debt may be forced to pay off debt instead of paying dividends.
FORMULA
Debt-to-profit = Total Debt / Annual Net Profit
The debt-to-profit ratio is often called "gearing". It can be seen in corporate reports expressed as debt-to-EBITDA. Generally, the lower the "gearing", the less risk the company carries.
Sometimes raising money through debt makes sense if, for example, it means taking advantage of low interest rates or increasing production capacity. Having debt isn't necessarily a bad thing; what matters is being able to pay off the debt, and the debt is being used to grow.
Sometimes raising money through debt makes sense if, for example, it means taking advantage of low interest rates or increasing production capacity. Having debt isn't necessarily a bad thing; what matters is being able to pay off the debt, and the debt is being used to grow.
5. Price-earnings (P/E) ratio
If there’s one ratio people tend to know about, it's the P/E ratio, and for a good reason. This is the ratio between the price of the stock and its earnings.
FORMULA
PE ratio = Share price / Earnings per share (EPS)
High P/E ratios (over 20) typically mean a stock is overvalued, while low P/E ratios (closer to 10) mean a stock is probably undervalued.
Growth stocks tend to have high P/E ratios because they are not earning high profits. This is because the money earned is being reinvested to foster growth. Dividend investors are not looking for high-growth opportunities but rather companies with stable earnings.
When you’re planning to hold onto a stock for a long time, there’s no need to go bargain hunting, but you don’t want to buy a stock with a high valuation. By definition, the slower growth of a stable company does not justify a high P/E ratio, meaning the share price has a higher chance of falling below where you bought it.
Growth stocks tend to have high P/E ratios because they are not earning high profits. This is because the money earned is being reinvested to foster growth. Dividend investors are not looking for high-growth opportunities but rather companies with stable earnings.
When you’re planning to hold onto a stock for a long time, there’s no need to go bargain hunting, but you don’t want to buy a stock with a high valuation. By definition, the slower growth of a stable company does not justify a high P/E ratio, meaning the share price has a higher chance of falling below where you bought it.
Recap
There are a number of factors that can make a stock a good dividend stock. From a qualitative standpoint, the stock is typically a well-established company with a strong track record of profitability and a history of paying out regularly to shareholders. The company should also have a solid financial position, with a healthy balance sheet and consistent cash flow.
From a quantitative standpoint, a stock should have a high dividend yield (DY) and a low payout ratio. The DY is a measure of the annual payout as a percentage of the stock's current price, and the payout ratio is a measure of the company's dividend as a percentage of its earnings.
From a quantitative standpoint, a stock should have a high dividend yield (DY) and a low payout ratio. The DY is a measure of the annual payout as a percentage of the stock's current price, and the payout ratio is a measure of the company's dividend as a percentage of its earnings.
