How to Pick Dividend Stocks

Dividend investing is a popular way to earn passive income. So, this post describes ways to evaluate dividend stocks to create a sustainable income from your portfolio.

What are dividends?

Dividends are cash payments made by companies to their shareholders. If you own shares in a company that pays dividends, then you can expect to receive regular cash payments to your account. Usually, these payments are made on a quarterly basis.

For example, Royal Bank of Canada (“RBC”) is the largest company in Canada, and a popular dividend stock. At the time of writing, each share costs $124.34. And because RBC is a profitable company, it pays a dividend of $1.28 per share each quarter.

Say you invest $1,243.40 and purchase 10 shares of RBC, you will then be entitled to receive a dividend of $12.80 each quarter, or $51.20 per year.

What is a Dividend Yield?

To calculate a “dividend yield”, simply divide the annual rate of dividends a stock pays by the value of each share. For example, if RBC pays a $1.28 dividend each quarter and the shares are trading at $124.34, then the dividend yield on RBC is currently 4.11% = (($1.28 * 4) / $124.34).

Looked at another way, if you invest $10,000 into RBC and receive a yield of 4.11% on your investment, you will receive $411 per year or $102.75 per quarter of dividends.

How to tell if a dividend is sustainable

• Yield
• Payout Ratio
• Financial Statements
• Valuation
• History
• Industry Type
• Company Policy

While it might seem appealing to simply find the highest yielding dividend stocks and invest in those exclusively, investors should remember that the public market has already discounted the risk of various dividend investments. And, there is no free lunch.

A higher dividend yield isn’t necessarily better than a lower dividend yield. You might find stocks with high dividend yields are also riskier and are more likely to cut their dividends rather than raise them in the future. So, below are some ways to determine whether a dividend is sustainable or not.

Dividend Yield

When a stock has a very high dividend, it should raise red flags for investors. Companies that pay high dividends might not be sustainable. Investors refer to unsustainably high dividends as “dividend traps”.

Investors should compare the a stock’s dividend yield to the average dividend yield for all stocks. For example, a company with a dividend yield of 2% might be more sustainable than a company with a dividend yield of 8% when the average dividend yield is 3%.

To determine whether a dividend is sustainable, investors must dig a little bit deeper.

Payout Ratio

The next place to look might be to consider a company’s “payout ratio” or “earnings coverage”. This is the amount of profit or free cashflow a company earns compared to the dividends they pay. A company earning $1 of profit but paying out $2 of dividends might not be sustainable. But, a company earning $1 of profit and paying out 50 cents of dividends might be.

Balance Sheet

Investors might also look at a company’s balance sheet to determine whether a dividend is sustainable. Companies with high debt levels might be more likely to cut their dividends in the future compared to companies with low debt levels.

Some companies also borrow money or issue new shares and/or do both to make acquisitions to fund their dividends/growth. This type of financing is often called “dilutive”. So, another way to determine whether a company has a sustainable dividend is to look at their financial statements.

Valuation

Determining whether a dividend is sustainable might involve considering a company’s overall value. Metrics such as a price to earnings ratio (“P/E”) are easy to find and helpful for doing this.

If a company has a high P/E and a high dividend, it might be a sign that the company is a dividend trap. Whereas if a company has an average dividend yield and an average P/E it might be a sign of more sustainability.

History

Some companies have a long history of paying dividends. Top Canadian dividend stocks such as RBC, Sunlife, Enbridge, Canadian Pacific, and George Weston have been paying dividends for over 100 years. Many of these companies have also never reduced their dividends, in fact, they have consistently raised their dividends each year during good times and bad.

When a company has a long track record of success and it provides critical services that we all rely on, you can have more confidence that this company will pay dividends sustainably.

Type of Business

The nature of a business will also give you clues as to whether their dividends might be sustainable. A company in an established industry with large scale is more likely to be a sustainable dividend payer compared to a newly formed company in an emerging industry.

For example, RBC operates a continent-wide network of bank branches, provides capital markets services to the largest corporations in the world, serves millions of customers and has tens of thousands of employees. Competing with RBC is difficult because it has an established business model that operates on a global scale. This helps make RBC profitable and better able to sustainably pay dividends.

By comparison, Laurentian Bank of Canada is a regional bank operating mostly in the province of Quebec. It is 100 times smaller than RBC by market capitalization. Although Laurentian Bank of Canada has a higher dividend yield, it is riskier because of the nature of its business.

Company Policy

Many public companies have explicit dividend policies. So, before investing in a dividend stock, check to see what a company’s dividend policy is. Some companies aim to raise their dividends each year, and other companies pay a variable rate of dividends based on their earnings.

Many resource extraction companies such as mining companies and oil & gas companies pay variable dividends because their business is dependant on the price of the underlying commodity they produce which is oftentimes volatile. Other companies such as banks and utilities might determine dividends based on regulatory rules.

What about Real Estate?

Real Estate Investment Trusts (“REITs”) usually have high yields. Technically, the payments investors receive from REITs are not dividends but distributions of income. And, they are taxed less favourably than dividends outside of registered accounts. So, investors should be cautious about comparing the yield on a REIT to the dividend yield on a stock (its like comparing apples to oranges).

Even though most of the factors used to determined whether a dividend is sustainable can also be used to determine whether a REIT distribution is sustainable, a few quirks should be kept in mind.

Instead of the earnings of a REIT, investors should pay more attention to their Funds from Operations (“FFO”) and Adjusted Funds from Operations (“AFFO”). Because of certain accounting rules, REITs must record gains and losses from the fair market value of their properties on a regular basis, and this distorts their accounting earnings. Better to check their free cashflow in the form of FFO & AFFO to determine how sustainable their distributions might be.

Look for Dividend Growth Too

Although investors would usually like to receive more dividends, this also comes at a cost. When companies pay shareholder dividends, those companies are then left with less cash to invest back into their operations. This could therefore constrain their future growth. So, dividend investors should not only look for companies that pay sustainable dividends, but also for companies who can growth their business sustainably too.

Determine Your Own Goals

Let’s also remember that dividend investing is not always the best investment strategy for everyone. Investors should determine their goals before making any investment decisions. Some investors might be better off investing in high growth companies that don’t pay dividends because they are young and have high risk tolerance. Other investors might be in high tax situations where more dividends might not be useful.

So before searching for the best dividend investing strategy, determine your goals and then find investments that align with them.

Can dividends fund my lifestyle?

Commonly, investors want to know how much capital they need to devote to dividend investing to generate enough dividends to sustain their own lifestyle. So, here is the answer.

Let’s say you’ve determined that you’d like to generate $3,000 per month or $36,000 per year from dividends to fund your lifestyle. How large would your portfolio need to be to generate this income from dividend stocks?

Divide your target level of income by the dividend yield you can expect to receive. Currently, since the dividend yield of the S&P/TSX 60 Index is 3%, then the capital you need to invest to earn $36,000 per year is $1,200,000.

After creating a budget, wealthy investors might determine they require $240,000 per year of income to support their lifestyle. This can be obtained by holding a dividend portfolio worth $8 million.

How to Find the Best Dividend Stocks

• Dividend Screens
• Indexes
• ETFs

Dividend Screens

Dividend investors should take advantage of the many stock market screening tools available. These can be found on financial websites. A good stock screener will usually have a dividend factor where investors can screen stocks for dividend yields, dividend growth, etc.

Indexes

Blue-chip indexes are a good place to look for dividend stocks. Simply look up a list of the S&P/TSX 60 Index or S&P 500 Index on Wikipedia and then determine which of those stocks pay dividends. If a company is in the S&P/TSX 60 Index or S&P 500 Index and pays a dividend, then it is more likely to be sustainable since these indexes track established companies that meet certain blue-chip investing criteria already.

ETFs

Exchange Traded Funds (“ETFs”) are a good place to look for dividend stocks. There are many different dividend indexes that have spawned their own ETFs and investors can visit the website for each ETF to view a list of the companies making up the fund. For example, the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF holds a portfolio of Canadian dividend paying stocks. At the time of writing, this ETF had a dividend yield that is 46% higher than the S&P/TSX 60 Index.

How about Index Funds instead of individual stocks?

Investors might consider using dividend ETFs instead of building their own portfolio of individual stocks. Using ETFs offers several advantages. It will reduce the time you might spend picking individual investments, it will reduce the individual investment decisions you need to make and therefore reduce the emotional bias you may exert on your portfolio, and it will give you greater diversification compared to a portfolio of a smaller number of individual stocks.

ETFs are probably suitable for most investors. But, ETFs also have a cost. Most dividend ETFs charge higher fees compared to broad based index funds. For example, the iShares S&P/TSX Canadian Dividend Aristocrats Index ETF charges an annual fee (“MER”) of 0.66% compared to the iShares Core S&P/TSX Capped Composite Index ETF with an MER of only 0.06% (10 times less).

The fees that you pay for ETFs are a drag on your returns. Looked at another way, if the dividend yield on an ETF is 4.5% and the annual fee is 0.45%, then the fee represents 10% of your dividend income each year. This is a high price to pay, especially when the holdings of all ETFs are made public and available for you to see.

In an age when no-fee online brokers exist, investors might be better off building their own portfolio of dividend stocks instead of using ETFs in some cases. But, this will depend on your preferences as an investor and the scale of your investments.

Our Family Office

Our investing style prefers passive dividend investing. We favour using ETFs and buy-and-hold type investing strategies that reduce transactions and increase sustainable income. With this income, we encourage our clients to take a purposeful view of the impact they can make from their investments that includes philanthropy.

Please get in touch with us if you would like to learn more about the services we provide.