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I want to cover the grounds on a more philosophical discussion in regards to dividend growth investing, annual dividend yield. A number of investors make a final investment decision only by analyzing a company’s annual dividend yield. This does not always tell you the final picture and can blow up an entire dividend investment portfolio.
Do Not Use Annual Dividend Yield When Investing
Dividend investors tend to track annual dividend yields for companies to determine an investment decision. This is usually done by tracking the annual dividend yield with historical annual dividend yields.
If the dividend stock’s yield is higher today than the historical average then it’s a SCREAMING BUY. That can leave a dividend investor in the dust.
Wishing they had never invested in that horrible stock. Follow these points when investing and building your dividend portfolio to avoid that one mistake you do not want to make.
Our guide to finding undervalued dividend growth stocks is a good start to realize the other considerations before investing.
Then, start analyzing profit growth of the undervalued dividend growth stocks. This is a key indicator for future dividend increases.
What is annual dividend yield?
In order to calculate an annual dividend yield, you need to take the dividend payments times the frequency of the payments to arrive at an annual dividend figure.
From there, you take annual dividends divided by the stock price to arrive at an annual dividend yield. Our free dividend discount model can show why you can’t always rely on what a dividend payout is right now.
There is So Much More to a Company than a Dividend Payout
Annual dividend payments are only a snapshot in time of what a company is paying out now. Many dividend stocks continue to make dividend payments just because they have done so in the past.
Is the dividend stock really fit to make those payments now? Has growth slowed recently? What does their balance sheet look like? Let’s be honest. The future is the million dollar question. We’ve helped you with how to forecast the dividend growth rate, but what about forecasting a company’s future in general?
First Consideration for Dividend Investing: Free Cash Flow
Do you want to be stuck investing in a dividend growth stock that grows its dividend at 1% per year the next five years? I didn’t think so. Take a look at the Company’s current cash flow and prospects for cash flow.
We want companies that generate significant free cash flow. Has the company made significant investments in capital expenditures the past few years? Or do they anticipate future capital expenditure needs?
I love high margin, strong free cash flow generating businesses. This reinforces financial stability since a company is able to be extremely flexible with their cash flow from operations.
This allows a company to pay handsome dividends, reward shareholders with buybacks AND/OR reinvest the money back into the business for growth.
Second Consideration for Dividend Investing: Financial Health
Financial health is paramount in dividing investing. We don’t invest in dividend stocks because of what they used to pay in dividends. We invest in dividend stocks for what they are going to pay in dividends.
While you can use and should use historical growth rates as a potential proxy for future dividend growth, it should not be the only method in your analysis. You need to review the balance sheet to understand the company’s ability to pay future dividends:
- Debt: Review the company’s current capitalization of debt by evaluating the following questions in your checklist:
- Take a look at the Total Debt / EBITDA ratio
- What is the interest rate on current debt?
- What is the company’s current credit rating? Is the company considered investment grade?
- What is the current debt outstanding?
- Working Capital: You will need to review the company current assets and current liabilities to ensure that there is adequate coverage and the company isn’t masking working capital changes as a form of cash flow benefit.
- What is the current ratio (current assets divided by current liabilities) of the company? I like companies that have a current ratio of 1.5x or greater. This should ensure sufficient coverage of the current liabilities with their current assets.
- Other liquidity ratios: I like to take a brief look at the quick ratio and other liquidity ratios to ensure that a company is able to make payments and remain solvent if growth slows at the business.
Concluding Remarks on High Quality Dividend Stocks
We are patient investors. However, there is nothing worse than investing in a dividend stock that now hit a financial roadblock and is prioritizing debt repayments over dividends. Use these financial ratios to evaluate whether or not a dividend growth stock is a good investment.
Take the above into consideration when considering a dividend growth stock investment. By only review the annual dividend yield, you miss the finer details of a dividend stock.
A quality dividend stock could turn into a dividend downer in a matter of weeks. Living off dividends is achievable so long as you follow my 5 favorite steps.
Consider buying one of these best dividend investing books to help you expand your knowledge.
Are you investing in quality dividend stocks? Do you solely use the annual dividend yield to make an investment decision? Please let us know in the comments below.
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