Invest in Dividend Stocks

If you have a long-term investment horizon of at least ten years, your best investment may not be mutual funds, ETFs, growth stocks, bonds, or gold. Instead, consider investing in a diversified portfolio of high-quality, dividend-paying stocks. Follow these steps to build a portfolio that will achieve high long-term returns and provide dependable dividend income.

Steps

Choosing Stocks That Pay Dividends

  1. Learn how dividend stocks produce yields. A stock's return consists of both share-price growth and dividend yield. For example, a company that pays a 5% dividend yield in a given year and appreciates in share price by 5% that same year, provides an annualized 10% pre-tax return to stockholders. High quality (dependable growth) is necessary to ensure that the dividend payout will be consistent (or even increase) year after year.
    • Companies pay dividends because their estimate of return by keeping the money internally is not high. This means that those companies that pay dividends do so because they are not reinvesting profits in order to grow.
    • However, growth companies are more interested in reinvesting their capital in order to grow their operations and (hopefully) their share value, so these companies do not pay dividends.
  2. Compile a list of candidate stocks. There are thousands of stocks on the market, but not all are suitable for dividend investors. There are several ways to narrow your search for top-quality dividend stocks:
    • Research the 30 stocks from the Dow Jones Industrial Average (DJIA). These are large American companies that are leaders in their respective industries. Many of them have the high-quality characteristics required for long-term performance, but some may not. This list is important, because it is a widely used benchmark for the U.S. stock market. Evaluate each company on the list in light of the criteria discussed in later steps.[1]
    • Use an online stock screener such as eSignal to screen for stocks with a market cap of at least 100 million dollars and a dividend yield of at least 150% of the Standard & Poor's 500 average yield. (If the S&P 500 averages a 2% dividend yield, look for stocks with at least a 3% dividend yield). Search also for stocks with a five-year average return-on-equity of at least 15%, a long-term debt-to-equity ratio of less than 1, interest coverage of at least 5% (see note in the Warnings section), and a 10-year earnings-per-share (EPS) growth of 5% or more. This should narrow down the list of candidate stocks considerably. In fact, most stocks found by an online stock screener will fail to satisfy this list of criteria in full and thus will not qualify as high-quality dividend stocks. Additional research is necessary, as outlined in later steps.
    • Look at the list of holdings of Understand Mutual Funds that invest primarily in high-quality dividend stocks, such as (among many others) the Vanguard Dividend Appreciation Fund. [2] Such a list contains good suggestions for finding high-quality dividend stocks.
    • Find a list of dividend achievers, those stocks with a history of raising dividends over time. Look for such a list in the financial press, on financial websites, or from certified financial advisors.
    • Look at the list of dividend aristocrats: stocks that have consistently increased dividends every year for at least 25 years. You can find the most updated list by doing an internet search. This list of blue chip stocks consists of top-quality dividend stocks that meet the criteria mentioned here.
  3. Use the Internet for research. From the list of candidate stocks, use an online financial website such as money.msn.com to investigate each company. Look at the financial statements over the past ten years, and immediately eliminate from further consideration any company that shows EPS loss in any of the past ten years.
    • For example, on money.msn.com, type in the stock ticker symbol (e.g. "T" for AT&T). On the stock page click on the "10-year summary" tab located at the bottom of the left panel, and look for any EPS deficits. For AT&T, there is red ink (an EPS loss) for the year 2008, so it must be eliminated from further consideration.[3]
    • If a company does not have at least a ten-year history of earnings, do not invest in it for the purpose of earning dividend income. It has not yet demonstrated an ability to generate consistent earnings and is therefore too risky to be considered a good investment.
  4. Analyze financial strength. There are several key measurements that will help indicate a high quality stock. Look at the balance sheet and income statement for the following key measurements of financial strength:
    • Low debt-to-equity ratio. It should be less than 1. To calculate, look on the balance sheet and divide total liabilities by total shareholders' equity.[4]
      • Some companies with low or medium levels of debt can still be good investments. Key is their ability to pay debt comfortably. The debt can also be used to leverage returns to shareholders.
    • High interest coverage (net interest earnings that are at least five times interest expense, found on the annual income statement).
    • No shares of preferred stock listed on the balance sheet. Preferred stock can be more costly to the issuing company than are bonds. However, this depends on the terms of the preferred stock issuance. A convertible, non-participating preferred stock issue could have a lower cost than debt.
    • Ideally, total current assets should exceed total current liabilities. (Look on the balance sheet.) This can give you confidence that the company will not run into any immediate cash-flow problems. A current ratio (total current assets/total current liabilities) greater than 2 is desirable but not mandatory.

Analyzing a Dividend Stock's History

  1. Look for uninterrupted dividend payments. Go back at least the past ten years, preferably 20 years (the longer, the better). You can get this information from the company's website. Furthermore, the dividend should be increasing every year, or at least every two to three years. Stocks that do not pay dividends or do not fulfill these criteria should be rejected.
  2. Look for high return-on-equity. A five-year average of 15% should be the minimum, and 20% or more is preferred.
    • To calculate return-on-equity, divide net income (from the income statement) by shareholders' equity which is assets minus liabilities (from the balance sheet).[5]
  3. Look for dividend growth. It should be at least 5% per year for the past ten years (the higher the better). Keep in mind, however, that a very high dividend growth rate (greater than 30%, for example) is unsustainable. To provide a margin of safety, look for a payout ratio (divide dividends by net-earnings) of less than 40%.
    • This payout ratio rule does not apply to utilities, real estate investment trusts (REITs), or master limited partnerships (MLPs).
  4. Look for rising earnings-per-share (EPS) and rising sales. Go back at least the past ten years. Sales growth fuels earnings growth, and earnings growth fuels dividend growth. Without fuel from sales and earnings growth, dividend growth will not last.
    • To calculate earnings-per-share, divide net income (from the income statement) by the average outstanding common shares. (from the balance sheet)[6]
    • While dividend growth is certainly a hedge against inflation, some investors do not consider dividend growth as important as simply receiving consistent, level dividends year after year.
  5. Study the companies that fulfill the above criteria. Look for indications of a long-range competitive advantage and thus continued profitability. Companies that sell non-durable goods such as Johnson & Johnson (drugs), Procter & Gamble (household care products), and McDonalds (fast food) tend to remain profitable during both recessions and prosperity.
  6. Rank the list of investable stocks. Calculate or look up P/E (price-to-earnings) ratios and then rank them from lowest to highest. Calculate these ratios using average earnings over the past three years in order to minimize the effect of any unusual earnings periods (containing large but non-recurring expenses or income). Also calculate price-to-book (P/B) ratios and price-to-sales (P/S) ratios. The lower these are, the better.
    • To calculate a price to earnings ratio, divide the current stock price by earnings per share (found on the balance sheet.[7]
    • To calculate price-to-book ratios, divide the current stock price by total assets minus intangible assets and liabilities. (from the balance sheet[8]
    • To calculate price to sales ratio, divide the current stock price by sales per share for a 12 month period. Find the sales amount on the income statement and the number of shares on the balance sheet.[9]

Managing Your Portfolio

  1. Engage in dollar-cost-averaging. At regular intervals (weekly, monthly, quarterly, etc.) invest recurring sums in one or more companies with relatively low P/E ratios. See the method about analyzing the stock's history for how to calculate P/E ratios.
  2. Diversify your stock holdings. You will want to include stocks from several different industries. Select companies in health care, consumer staple goods and energy production, as well as financial firms, innovators in technology, industrial plants, telecommunications, utilities, and real estate trusts.
  3. Read the quarterly and annual reports. These are called 10-Q for quarterly and 10-K for annual reports. You want to make sure the prospects for the stocks you hold remain positive. If a company decreases its dividend or fails to increase it over a one- or two-year period and doesn't cite a good reason for doing so, it may be time to sell.



Tips

  • For most companies, low P/E is more important than low P/B. Financial stocks and REIT's are major exceptions to this rule. A price lower than book value is especially desirable in the case of financial stocks.
  • Stock dilutions are bad, and stock buybacks are good for investment returns. Look at a firm's ten-year financial summary, and look for a decreasing or level number of shares outstanding. Increased shares lower the earnings-per-share and dilute the existing shareholders' stake in the company. A decreased number of shares increases the earnings-per-share and the existing shareholders' stake. Reject stocks with a rapidly expanding number of shares outstanding. Favor stocks with decreasing shares.
  • Don't overpay for good-quality dividend stocks. Ideally, P/E, P/B, and P/S should all be less than the S&P 500 average ratios. In any case, if P/E exceeds 20, P/B exceeds 6, or P/S exceeds 2, do not buy. Instead, set a target price and wait patiently to buy when the stock falls to your target price. Remember that the next bear market (when stocks go on sale) is always right around the corner.
  • Reinvest all your dividends. If your broker offers a free dividend-reinvestment option, take advantage of it.
  • Build a diversified portfolio of 15 to 30 top-quality dividend stocks. Owning fewer than 15 stocks may mean that you're not adequately diversified against company-specific risks (BP in the 2010 oil spill is a good example of this). Owning more than 30 stocks is not necessarily a bad thing, but it might become rather cumbersome to monitor all your stock holdings adequately.
  • Consider buying stocks directly from the issuing companies via a Direct Stock Purchase (DSP) plan. This is appropriate when you are investing for the long term (15 years or more) and not particular about timing your purchases precisely. It allows you to buy stocks without broker commissions or fees in some cases, allows automatic reinvestment of dividends to build your position, entitles you to receive any shareholder perks offered by the company as a registered shareholder on the company's books (instead of the use of a "street name" when you buy through a broker), and allows you to dollar-cost-average by investing a fixed sum (such as $50) automatically withdrawn from your bank account at regular intervals (a strategy beneficial to the shareholder). From the list of high-quality stocks that meet the above criteria, search online or call each company to see if a DSP plan is offered. If so, ask for a prospectus and enrollment form. If the fees are acceptable (lower than you would pay a broker), and other terms of the plan are satisfactory, enroll in it.

Warnings

  • Don't aim for unrealistically high current dividend yields. A 20% dividend yield is likely to be unsustainable. Similarly, don't rely on projections of generous future dividend growth. Crystal balls are in short supply.
  • Dividend cuts kill stock prices. Make sure companies in which you invest maintain their high-quality status. That means low debt-to-equity ratio, high interest coverage (where interest income substantially exceeds interest expense), increasing revenues and earnings, high return-on-equity and a dividend-payout ratio (earnings-to-dividends paid) no higher than 60% (except for utilities, REITs, and MLPs, which commonly have high payout ratios).
  • Avoid companies in commodities-based industries, such as Phelps Dodge (copper) and Alcoa (aluminum). Such companies are cyclical, as their earnings are unpredictable and dependent on the price of the commodity. They offer no reliable prospects for long-term growth and therefore should have no part in a long-term investment portfolio.

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Sources and Citations

  1. ↑ http://money.cnn.com/data/dow30/
  2. ↑ https://personal.vanguard.com/us/FundsAllHoldings?FundId=0920&FundIntExt=INT&tableName=Equity&tableIndex=0&sort=marketValue&sortOrder=desc
  3. ↑ http://www.msn.com/en-us/money
  4. ↑ http://www.investopedia.com/ask/answers/062714/what-formula-calculating-debttoequity-ratio.asp
  5. ↑ http://www.investopedia.com/ask/answers/070914/how-do-you-calculate-return-equity-roe.asp
  6. ↑ http://www.investopedia.com/ask/answers/070114/what-formula-calculating-earnings-share-eps.asp
  7. ↑ http://www.investopedia.com/ask/answers/070314/how-do-i-calculate-pe-ratio-company.asp
  8. ↑ http://www.investopedia.com/terms/p/price-to-bookratio.asp
  9. ↑ http://www.investopedia.com/terms/p/price-to-salesratio.asp
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