Here’s Part 5 of our income investing series. You can check out Parts 1, 2, 3 and 4 here, here, here and here.
Today, we explain commonly-used terms when it comes to dividends.
Dividend Yield
The dividend yield is calculated by dividing the dividend amount by the prevailing share price of the stock.
Attractive dividend stocks typically pay about 4-6% dividend yield on the prevailing share price.
There is no free lunch in the world.
While a higher dividend yield may reward you more handsomely, it could also be a warning sign for a dividend trap.
High yields in comparison to the industry average tend to be unsustainable, especially over the long run.
Therefore, it pays to watch out for high yields when it comes to selecting good dividend stocks.
Lower yields might not necessarily be bad too, if the company has good growth potential and has a track record of growing its dividends.
Patient investors who hold such stocks long enough can reap high dividend returns because of a lower initial capital outlay.
Payout Ratio
The payout ratio is the proportion of dividends paid out of a company’s annual earnings.
From its earnings, companies can either choose to pay dividends or reinvest the money to grow the business.
For mature companies with little growth potential, a higher payout ratio is appropriate.
Smaller companies with space to grow should, instead, invest more in themselves. Such companies may wish to withhold dividends as they grow rapidly.
Do watch out for companies with unusually high payout ratios relative to their industry and size.
This is another key warning sign that current dividend levels are not sustainable.
These companies might be using past earnings or even borrowings to sustain their dividend payouts.
Stable Revenue & Profit
Another important aspect to consider when choosing a stock for your dividend portfolio is consistent revenue and profit.
After all, we cannot continue to collect water from a well that is about to dry up!
The key is to examine the company’s income history, business model and industry prospects.
A company needs to generate consistent profits in order to continue paying a dividend.
If you do not see the company sustaining its profits over the long-term, you should stay away.
Another attribute to consider is the characteristics of the company’s business and revenues.
Software as a service companies, as well as companies selling everyday consumer items, are more likely to be able to maintain their revenues even in a downturn.
Free Cash Flow
After profits and revenue, free cash flow (FCF) should also be consistently positive for a stock to be considered in a dividend portfolio.
FCF is the amount of cash flow a business has left over after using its operating cash flow to pay for capital expenditures.
Profitable businesses do not always generate free cash flow every year.
This is because there could be monies that have not been collected or expenses that have been paid in advance. These are known as timing differences and should resolve themselves over time.
Companies with insufficient free cash flow might still maintain their dividends through other means such as borrowings, so it is important to do your research on how the company is paying for their dividends.
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