Many stocks pay a dividend. But not every dividend stock is worth owning.
Some companies may be on the verge of cutting their dividends, thus giving a false impression of high dividend yield.
Other companies could see their business languishing, thus choosing to pay out more cash because of an absence of growth opportunities.
Though dividends may be increasing, the core business may continue to decline and result in capital losses for investors.
Ultimately, you should be looking at how the business is performing to determine if it can continue to churn out consistent dividends.
When you focus on the select few dividend champions, you may be rewarded by stocks that can continue to pay rising dividends over the years.
There are specific attributes to watch out for when it comes to locating a great dividend stock.
Here are two of them.
Consistent, strong free cash flow
Free cash flow is the hallmark of a company with a strong core business.
In a nutshell, free cash flow is what you get after deducting capital expenditures from operating cash flow.
Businesses that churn out consistent free cash flow year after year are well-positioned to continue paying out dividends.
In essence, free cash flow represents an excess of what the company needs for its operations and to pay its staff.
The rest of the cash can be utilised in any way the company chooses.
It may either buy back shares or use it to pay out a dividend.
When assessing a potential dividend stock, you should plot out a five to 10-year history of the company’s free cash flow.
If the majority of those years sees strong, positive free cash flow that exceeds the dividend payout, there’s a high chance the company is also a consistent dividend payer.
Sturdy balance sheet
The second attribute of great dividend stocks is their sturdy balance sheet.
By being “sturdy”, the company has significant amounts of cash or liquid assets, and either no debt or minimal debt.
With a large cash stash, the company relies much less on financing activities such as bank loans and borrowings to fund its operations.
More importantly, a large cash buffer also stands the company in good stead to withstand a crisis or downturn.
The cash could be used to continue dividend payments even when economic conditions deteriorate.
With low debt levels, the business is not beholden to banks and does not have to tie up its assets as collateral.
Finance charges are also kept low or are non-existent, thus allowing the business to enjoy even more free cash flow to pay dividends with.
So remember, when hunting for dividend stocks, you should always check how robust the business’ balance sheet is.
The more sturdy it is, the more likely it can continue to pay out dividends through good times and bad.
Get Smart: Growing dividends
Aside from the two attributes described above, you should keep an eye out for businesses with strong competitive moats and good prospects.
A strong moat ensures that competitors cannot easily take market share away, allowing the company to continue to churn out copious amounts of free cash flow.
It’s important to always be wary of potential competitive threats or products or services that may substitute those sold by the company.
A company with great future prospects within a growing industry may also churn out increasing levels of dividends over time.
Such stocks, if held on for a long period, can effectively compound your wealth and allow you to retire with peace of mind.
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Disclaimer: Royston Yang does not own shares in any of the companies mentioned.
