What should you look for in dividend paying stocks? Time to put the rubber to the road and get into our selection criteria for finding quality companies. First we’ll outline our quantitative criteria then our qualitative.
Here we go...
As mentioned previously, a company that’s saddled with debt has fewer options when the economy gets tough and when interest rates rise. We like to make sure the companies we invest in are financially stable and can weather any storm.
To be safe, we look for good dividend paying stocks with a maximum Debt to Equity Ratio of 50%. When the going gets tough, a dividend paying company with low debt to shareholder’s equity will not suffer from a heavy debt burden.
There are some exceptions such as when earnings are very predictable but the interest on debt should still be covered by after tax earnings at least 3 times over.
As dividend investors we want to make sure our dividend is safe and sustainable! So we look for companies that pay out a maximum of 60% of their earnings in dividend payments to shareholders.
This leaves at least 40% of earnings as a margin of safety to cover the dividend if earnings are affected temporarily by some unforeseen event. A low payout ratio also allows the company to increase the dividend even if earnings are temporarily affected.
After paying out dividends, a company should have enough remaining to invest for growth in future earnings and a low payout ratio lets them do this.
There are some exceptions to this rule such as REITs and we will cover those later on.
As we discussed previously, Return on Equity measures the profitability of a company. We like the companies we invest in to be profitable enough to finance growth out of the earnings left after paying dividends.
We don’t like a company that has to raise more money or take on more debt regularly to invest for growth.
So we look for Return on Equity to be at least 15% and to be consistent from year to year. If a company’s ROE is 10% one year and 30% another year then they are not getting consistent returns on the money shareholder’s have invested in the company and we don’t like that!
High yield stocks gave us cash to reinvest! You'll be further ahead with a stock that has a high current yield and moderate dividend growth then you would with a low yield stock with high annual growth.
Dividend growth is also less certain than dividend payments so we look for a yield of at least 3%.
It may be tempting to look for the highest yields available but this may be a trap. Click here for why high yield dividend stocks can be dangerous. Abnormally high yields often signal an underlying issue with the company.
When we look at past earnings, we like to see annual growth in the high single to low double digits consistently. This is because we also look for dividend growth to be in the same range.
The earnings have to support the dividend increases or the payout ratio will keep rising and that's a red flag!
We also look at how earnings held up in past recessions. Was the company still able to grow earnings in a challenging environment?
With the companies we're looking for, earnings shouldn’t be drastically affected regardless of the economic state. This is because they sell products globally that people need no matter what.
Since we’re dividend growth investors, we want growth! We look for dividend paying stocks with a history of growing payouts to shareholders by at least 10% annually.
In tough times dividend growth may slow down a little. However, we’ve found that stock prices usually come down as well which causes the yield to rise! A higher yield makes up for the temporary slowdown in dividend growth.
You will do very well in the long run if you purchase high quality stocks at low prices.
We also look for a stock dividend growth history of at least 20 consecutive annual increases. This shows that a company was able to increase their dividend payouts through multiple recessions in the past.... a survivor and thriver!!
You can find a list of dividend paying stocks that meet this criteria in the Dividend Achievers Index. This excellent resource tracks dividend champions that have increased their dividends every year for at least 25 years!
Ok so that wraps up our quantitative criteria for finding dividend paying stocks. See below for a couple great articles on the qualitative aspects we look for...
Management Quality is Key to Long Term Performance!
What is Competitive Advantage?
Congratulations! You are well on your way to becoming a successful investor now that you know what we look for in dividend paying stocks.