Factors to Consider
before Investing in Dividend Paying Stocks
Before investing in stocks that offer a
solid source of income, there are some factors to consider, besides
weighing the risk and rewards.
Have Been in Business for Some Time
Generally, income stocks have been in the business for a while. They
have actually achieved a certain growth phase. Dividend stocks are
usually low in capex (capital expenditure). These companies have
strong cash flow and do not need money for future expansion. They
have made their initial investment, need not incur new investment to
add on new capacity and thus are able to pay out dividends.
Historically, dividend-paying stocks are MNCs, where majority are
market leaders in the country and usually will not extend their
businesses overseas. The dividend payout is high because this is how
the owners get the returns from their investment.
Use Dividend Yield As Guideline for Stock
Selection
Dividend yield is a financial ratio to measure of how much income
you are receiving for each dollar invested. The higher the yield of
a stock, the more attractive it is to its investors. For example,
Company A with current market price of $2 is paying 10 cents per
share of dividends, while Company B with current market price of $5
is paying 20 cents per share of dividends. While the absolute
dividend amount for Company B is higher, the dividend yield for
Company B is 4% (20 cents / $5 x 100) and the dividend yield for
Company A is 5% (10 cents / $2 x 100). However, experts agree that
the identification of dividend-paying stocks should go beyond merely
analyzing their dividend yields.
Track Record of Dividend Paying
Companies that have a solid track record are worth investing in.
These companies actually have a good track record in paying high
dividends year after year. It is a good idea to identify counters
that have paid dividends consistently for 5 to 10 years.
It is also important to ensure that the dividends are sustainable.
How can you ensure that? One way is to compare the dividend yield
and earnings yield. For example, if the dividend yield is 5.5% and
the earnings yield is 6%, that means the company is paying 90% of
its profits back to the shareholders. You have to make sure the
price-to-earnings ratio (PER) that particular year was low and
therefore would be readjusted the following year.
Gauging Future Payout
Determining the dividend payout ratio of previous earnings can give
you a better prediction on future dividends. You have to find out
whether the company follows the payout ratio strictly through good
and bad times. Some companies may choose to stick to absolute
dividend per share (DPS) payment.
Invest in Low-Gearing Companies
Stocks with stable revenue are not necessarily good dividend payers.
For instance, some infrastructure stocks usually have a low dividend
payout. This is mainly due to their high gearing level. The
bondholders have priority over the shareholders.
While companies do not adjust the dividend based on interest rates,
if a company has borrowings and the interest rate is going up, the
company would probably prefer to settle the borrowing than pay
higher dividends.
Consequently, it is good to give attention to companies with low
gearing level. The gearing ratio is usually calculated by dividing
the amount of borrowed funds to the owner's equity. Look at those
with a gearing of 50 and below.
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