When picking a stock with an emphasis on dividend payments, you are typically looking to maximize your return over a longer period of time instead of picking stocks purely for appreciation in its value. As with selecting stocks for other aspects of your portfolio, dividend-focused investment is not as simple as just looking at the current dividend yield (expressed as a %, the stock’s dividend payout compared to the stock’s price) and making a decision.
Sometimes the highest yield isn’t necessarily the best investment as there are several other things that you need to consider.
When choosing stock for its dividend yield you are going to want to look at the historical performance of that stock’s dividend payouts. The dividend yield of a stock will typically move back to its long-term average, so if you have a stock with a 6% yield now but a historical average of 4% you can expect the dividend yield to drop over time. Conversely, a stock with a 2.5% yield now but a historical average of 5% will likely see an increase in the dividend yield over time. Therefore looking at two stocks at a single point in time, one with a 6% current yield and the other with a 2.5% current yield may not be representative of what you can expect over time.
In addition to looking at historical trends, when assessing a company’s ability to pay dividends over time it is important to look at its Free Cash Flow. This is a financial metric that shows you how much cash the company has to pay out dividends and invest in itself without seeking financing for growth. If over several years Free Cash Flow has shown a positive trend you can expect the company to be able to continue to pay dividends. If Free Cash Flow has been negative then the company will increasingly be devoting cash to paying off financing, straining its ability to sustain dividend payments.
When investing in a dividend-focused stock you need to keep in mind that you are still investing in actual stock and the price of that stock will have a bearing on your investment return. If you get great dividend returns over a 2-3 year horizon but the stock drops by 20% you can easily wipe out your profits. As such it’s very important to ensure that you look into the underlying fundamentals of the stock that you are choosing and have confidence that you are likely not going to take a loss on the value of the actual stock. Stocks with a low debt to equity ratio and a low price to earnings ratio, when compared to their peers, recommend themselves as dividend stocks to invest in.
In some cases, it may be better for you to consider investing in a dividend-focused mutual fund that buys stocks with an emphasis on their regular dividend payments. This is particularly a good idea if you don’t have the time to prepare your own assessments of the stocks or feel comfortable making your own assessments. These companies pick their stocks based on criteria similar to those discussed above and essentially do the work for you. Beware, however, of the management fees of any mutual fund you invest in as you can see drastic differences here (ranging from 0.5% to 6% of the investment returns) without seeing a comparable difference in the performance of the funds.