Published March 30th, 2021
This is a guest contribution from Chris Panteli of LifeUpswing
To be financially free means building a diverse portfolio of revenue streams. Investing in dividend stocks is a popular method for building passive income. If done right, investments can mean living the life you want. Early retirement, home ownership, and freedom to travel are all easier to do when those investments pay off!
How can you know what dividend stocks to invest in?
First, it’s important to remember that all investments carry some risk. There is no such as a sure thing. After all, if it was easy, everyone would do it.
Instead, to be successful at investing requires careful planning and a willingness to take some risk. I’ve put together these 4 vital characteristics to look for in dividend stocks to help you get a head start.
What Are Dividend Stocks?
A dividend stock is a stock that is held in a company that pays out regular dividends. These are usually established companies with a proven history of regular payouts to shareholders.
Payments may be made directly to your bank account or into your brokerage account. The good news is that investing in dividend stocks means seeing those payments on a regular basis! It could mean extra money each month!
How Do Dividend Stocks Work?
Let’s look at an example of how a dividend stock works –
To get started you buy 100 shares in Acme Inc. Each share costs you $10 and pays an annual dividend of $0.30. In total, you have invested $1000 for your 100 shares. Over the year you receive $30 in dividend payments which is an extremely healthy 3% yield.
Once you’ve been paid your dividend you can choose what to do with the money. You could spend it or save it. The money could be used to buy stocks in another company, or you might choose to use it to increase your stock in the existing company. Sometimes you might do a combination of all these!
The awesome thing about dividend stocks is that provided the company can, they will always pay out the agreed dividend whether the stock price has gone up or down.
4 Vital Characteristics To Look For In Dividend Stocks
Having the right investments means you can get a return on your investments even when the markets are down! Having a good strategy that aligns with your financial goals is the key to achieving that success. Investing can seen overwhelming at first. The good news is, there are many helpful investing courses that can educate investors on a variety of subjects, including dividend stocks.
Here are 4 vital characteristics to look for in dividend stocks.
Vital Characteristic #1: Dividend Yield
A term that is used to describe the dividend to price ratio is known as the dividend yield. Simply put a high dividend yield means you will earn more dividends for every dollar spent when investing. Lower dividend yields mean earning a smaller amount per dollar spent when investing.
There are a couple of ways you can calculate a stock’s dividend yield. First, you could work out a per-share calculation. To do this you must divide the total dividend per share paid over the year by the price of the stock. For example, in a year a $10 stock pays $0.50 out in dividends. This means the dividend yield of the stock is 5%.
Another way to calculate the stock’s dividend yield is by total dividend calculation. A total dividend calculation is done by looking at the total amount of dividends paid. For example, a company is valued at $100 million and has paid out $5 million in dividends. The dividend yield is 5%.
Both methods can be used to work out a stock’s dividend yield, but whichever method you use does give the same result.
The dividend yield is a vital characteristic to look for. It’s important because it helps you calculate how much return you can expect to make on your investment. On average dividend yields go from 0% to 5%. There are a tiny number of companies with a dividend yield of 6% or more.
Use this data to help make good investment decisions.
Vital Characteristic #2: Dividend Payout Ratio
The dividend payout ratio is another fantastic metric that can help pick investments wisely, as it looks at what percentage of a company’s earnings are paid back to shareholders as dividends.
Calculating the dividend payout ratio is straightforward. Simply divide the total dividends paid out by the company’s earnings. For example, a company pays $10 million in dividends annually. The company has generated an annual net income of $20 million. This means the dividend payout ratio is 50%.
Most companies will keep some of the profits to reinvest in the company to maintain growth and improve infrastructure.
If the ratio is extremely high, such as 75% or more, this could be a warning that the company is paying out too much in dividends. If dividend payments are too high and the business starts struggling due to lack of investment, this will mean dividend payments will probably get cut in the future.
A low dividend payout ratio means that your share of the profits is going to be small. However, it usually means the company is spending more money on growing the company which could see bigger profits in the future if expected growth is achieved.
When choosing an investment, an ideal dividend payment payout ratio could be 35%-55%. Use this as a guide when choosing your investments.
Vital Characteristic #3: Dividend Growth Rate
When a company grows and its stock price goes up, this should mean that dividend payments go up. It’s only fair your share of any profits increases when the company is generating larger revenues!
To get a clear understanding of a company’s dividend growth you will need to check some history. Search for previous years’ dividend payments, the stock’s dividend yield history and make sure to also look for how much the company paid to its investors and when.
Ideally, you will find that there has consistently been a dividend increase over several consecutive years. If the dividend growth rate is positive, this is a good sign that the dividend stocks are worth investing in.
Vital Characteristic #4: Debt To Equity Ratio
A high debt to equity means a company has an excessive amount of debt. The problem with these companies is that they will often prioritize paying off those debts before paying out any dividend payments.
You should usually avoid companies with a high debt to equity ratio as you probably won’t see any returns until the debt is at a manageable level. This is something that could take years!
The debt-to-equity ratio is calculated by working out debt against equity. For example, if the company has a debt-to-equity ratio of 2, this means for every $2 of debt it has $1 of equity.
As a rule, a company with a debt-to-equity ratio of 2.0 or more is considered risky. When choosing your investments, you should take this into account but depending on other factors you may still think the investment is worth it. That’s fine of course! Just make sure you have checked this before making a final decision.
Why It’s Essential To Do Your Due Diligence
Investing in dividend stocks carries some risk. It may be tempting just to invest in stocks with the highest yield. However, this isn’t always the best idea.
A high dividend yield doesn’t guarantee long-term payouts. Sometimes a sector can be struggling, and stock prices have dropped, but dividend payments have still been made as the money for that hasn’t run out. This means in the long run you could lose money.
Therefore, doing your due diligence is essential. Make sure to check all the metrics listed to build up a big picture of how the company is doing. You can’t avoid all risks, but you can cut the risk down to a minimum by doing these checks.
Don’t forget – your goal is to make money! If you want to build wealth over the long term, then building a sound investment strategy by doing plenty of research is essential.
What are your life goals? Your goals might include early retirement, home ownership, and freedom to travel. To achieve these goals means you need to build wealth.
To build wealth means creating a financial strategy that will get you to where you want to be. A successful strategy will be diverse in its approach and include things like budgeting, increasing your income with a side gig, and dividend investing.
A good investment portfolio should be diverse with some investment in high-quality dividend stocks such as the Dividend Aristocrats. All investments carry an element of risk; however, dividend stocks are relatively safe and can see great returns if done right.
How you choose to invest will largely be dependent on your appetite for risk and your age.
If you are older or prefer low-risk investments, dividend stocks could be appealing. However, if you are willing to take risks or you are younger (which means you have more time to recover any losses), then spreading your investment between dividend stocks and alternative investments may be better for you.
Whatever you decide to do make sure to do your due diligence before investing anything. For best results check the 4 characteristics discussed above – dividend yield, dividend payout ratio, dividend growth rate, and debt to equity ratio.
Following these best practices means you can have a better chance of enjoying bigger rewards!
Hey, I’m Chris. I have a degree in Business Economics from the University of Liverpool, own a small fast food business, and run LifeUpswing.com. I will help you to make money, save money, and think about money in a way that will give you back your freedom.