If you’re considering investing in dividend stocks, then it is important to establish a firm understanding of the basics. Below, I’m going to cover some of the basic ideas that you’ll want to know before you begin picking dividend stocks for your portfolio.
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You must understand the strategy you want to follow. Here are a few strategies:
- Dividend Growth: Your goal is to grow your dividend return over time, and do so reliably. This will consist of choosing stocks with a track record of paying and raising dividends.
- Dividend Yield: Your goal is to maximize dividend yield. This may consist of chasing stocks with the best dividend yields. You will probably have a lot of turnover in this type of portfolio as many of the highest dividend yields are just simply unsustainable.
- Dividend Income: Your goal is to obtain a steady stream of predictable income. This will rely more on safe stocks with consistent dividends. The percentage yields tend to be lower as you’re looking for sustainability instead of yield. A lower yield is far easier to maintain, especially in poor economies.
- Tax Strategy: This strategy aims to lower the burden of taxes on your income. For the last few years, in the US, qualified dividends received no tax. That is set to sunset by 2013, but that doesn’t mean that taxes still can’t be hedged. Government Bond Dividend ETFs, and other tax focused funds are just the beginning. Tax efficiency is a big investment topic that you should certainly research in your investment journey.
Video: Are Dividends Timeless?
Mentioned just a little earlier, dividend yield is the percentage return your dividends represent. Dividend yield shouldn’t be the only number that you look at, but yield will help you determine how big your income is, how quickly your holdings grow and how sustainable a dividend truly is. I have an excellent article explaining the dividend yield formula and why it is important.
P/E Ratio & PEG Ratio
These two ratios will help you to understand if a stock is over or undervalued. P/E ratio simply tells you how many dollars you’re paying for each dollar the stock earned. Often, a P/E ratio of 20 – 25 is about the highest I’m willing to go, but I also look at other things, such as the PEG Ratio.
The PEG ratio also takes growth into account. This helps to justify certain stock valuations. For example, if a stock has a P/E ratio of 40, then I’m less inclined to look at it, but if it is on track to grow 80% (which would be a PEG ratio of .5 (40/80)) then I will be more inclined to look closely. A company with a PEG ratio of 1 is said to be “fairly valued”, a company with a PEG less than 1 is considered undervalued and a company with a PEG greater than 1 is considered to be overvalued.
Of course, PEG ratio does favor smaller companies, so evaluating blue chips this way will probably result in less-than-stellar numbers.
Video: What Is The PEG Ratio?
DPR or Dividend Payout Ratio is the percentage of earnings that are paid out in dividends. For a stock with a DPR of 70%, this means they are paying 70% of their earning out to share holders and are only leaving 30% to invest back in the company. A high DPR could result in the company not investing back into itself enough, and ultimately cost share holders more money in the long run.
EPS or Earnings Per Share growth is important to look at because it tells you if a dividend is on course to be unsustainable. If the DPR is really high, and the dividend yield growth outpaces EPS growth, then the dividend will easily begin to eat up additional earnings.
If you are looking at a company that is consistently growing their dividends faster than earnings, then you’re looking at a stock with an unsustainable dividend course. EPS Growth MUST outpace dividend yield growth in the long run or the company has two options:
- Cut the dividend
- Go bust
Neither one of those is conducive to a successful dividend stock portfolio. If a company has a low DPR and their dividend growth outpaces their EPS growth, then they will have some time to sort things out. You still want to be careful. As a side note, getting international diversification isn’t difficult, I even have an article about Canadian dividend stocks to get you started.
Hopefully this serves as a great resource. As always, this information is provided as educational only, and you should consult with your financial planner before making any decisions.
This article is a part of our free Stocks that Pay Dividends Training Course. Check it out now!