There are lots of people who are interested in investing in dividend stocks. Most of us have no clue where to begin when we are new investors though. With all the different stocks out there that pay dividends it can be challenging to decide which of these will be the best fit for your portfolio.
It is common for aspiring dividend investors to be lured into purchasing a company based on a high yield. However, an extremely high yield often signals a sign of financial uncertainty. Dividend sustainability is arguably the most important factor when deciding on which stocks to buy, especially for those looking for long term investments.
Analyzing a companies dividend is crucial when determining which stock to buy. The four major things to look for are; free cash flow to equity (FCFE), the dividend payout ratio, the dividend coverage ratio and the net debt to earnings before interest, taxes, depreciation and amortization (EBITDA ratio).
Free Cash Flow To Equity (FCFE)
Free cash flow to equity is measured by subtracting all expenses, reinvestments, debt repayments from net income and adding net debt. This calculation determines how much cash can be paid out to shareholders.
Dividends and FCFE are not the same thing though. FCFE is simply what is available to be paid to shareholders, a dividend is the amount that is actually paid to shareholders.
Investors usually want to see that the company’s entire dividend payments can be covered by the free cash flow to equity.
Dividend Payout Ratio
The dividend payout ratio indicates what portion of a company’s annual earnings per share is being paid in the form of dividends per share. The dividend payout ratio can be calculated by taking annual dividends per share (DPS) dividend by earnings per share (EPS). You can also calculate the dividend payout ratio by taking the total dividends paid divided by net income.
The magic number here is 50%. A company that pays out more than 50% of its earnings in the form of dividends is considered less stable and at a greater risk to cut dividends, or increase dividends at a lower rate. A company that pays out less than 50% of its earnings in the form of dividends is considered stable and has more potential to raise dividends and maintain dividends over the long term.
Dividend Coverage Ratio
The dividend coverage ratio is used to determine the number of times that a company could pay dividends to its shareholders using its net income. It is used to evaluate the risk of not receiving dividends.
To calculate the dividend coverage ratio take a companies annual earnings per share divided by its annual dividends per share.
A higher dividend coverage ratio is preferred (higher than one), this means the company can pay dividends to its shareholders more times than if it had a lower ratio. If a dividend coverage ratio is lower than one it may mean that the company is borrowing money to pay dividends.
Net Debt To EBITDA Ratio
The net debt to EBITDA ratio is used to determines a companies leverage and its ability to pay its debt. To calculate a company’s net debt to EBITDA ratio take the company’s total liability minus cash divided by its EBITDA.
A company with a lower net debt to EBITDA ratio is generally seen as more attractive when compared against other similar companies. Beware of divided paying companies that have high net debt to EBITDA ratios and have been consistently increasing, this may be a sign of an upcoming dividend cut.
Implementing these ratios can help you make informed decisions while picking which dividend stock to buy next. Buying stock in companies that you understand is critical and will ultimately lead to greater success for your investments. Remember, only you have the power to make informed choices, you must do your own due diligence and make investments that you are comfortable with.
What strategy do you use to pick your dividend stocks?