The appeal to invest in dividend paying stocks can be quite high. Receiving regular dividend payments can be enticing, especially to a new investor. I like to think that most new investors don’t know exactly where to begin but, they do want to make sure they are making good, informed purchases. With all the different dividend paying stocks out there it can be challenging to decide which of these will be the best fit for your portfolio.
It is common for new dividend investors to be lured into purchasing a company based on a high yield. However, an extremely high yield often signals signs of unsustainability. Dividend sustainability is arguably the most important factor when deciding on which stocks to buy, especially for those looking for long term investments. If the company tanks and you lose all your money, it doesn’t matter how great the dividend was. Analyzing a company’s financials is crucial when determining which stocks to buy. Four major things to look at 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 generally 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 generally 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 based on its net income. 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 determine a company’s leverage and its ability to pay its debt. To calculate a company’s net debt to EBITDA ratio take the company’s total liabilities 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 dividend 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.
By utilizing and understanding these measures can help make informed decisions while picking which dividend stocks to buy next. Buying stock in companies that you understand is critical and will ultimately lead to greater success for your investments.
