No stock is immune to market fluctuations and that includes dividend aristocrats. Dividends account for a fair chunk of the stock market return to investors, but just how can we choose dividend stocks that are considered safe? I’m going to run you through some factors you should consider when buying stocks.
There are numerous factors that can affect the price of a stock. These include how volatile the sector is; the size of the company; the valuation principle; how much of a cult following it has;
Seeking safe stocks is a smart decision to make for your portfolio. After all, who wants risky stocks that could lose you more than you earn through dividends? The issue is it’s not easy to analyze thousands of potential stocks and thus investors choose to look at a few values and what smarter individuals have to say.
Companies regularly release financial reports that can easily see the document length hit three figures. It’s on purpose too. They want to spin any news as good news and make sure it’s difficult for anyone who doesn’t have the time (or insight and experience) to spot anything to throw off future investments.
There are a few things you can look out for to help you screen potential dividend stocks.
The price-to-earnings (P/E) ratio is what determines the market value of a stock, compared to the company’s earnings. Generally speaking, a high P/E ratio could represent an overpriced stock, while a lower P/E could signal a better value purchase at that time. It’s useful to see whether you’re getting a good deal outright, even if you plan to dollar-cost-average.
The P/E is usually one of the first metrics investors check before the dividend yield and other important figures. Even if you’re only in the investment game for long-term dividend consolidation, the companies you invest in should be valued in your favour upon entry.
Apple-grade cash reserves
The bank balance of the company is also incredibly important. Should the stock market encounter turbulence, you’ll want to have investments in companies that can cover the cost of a dividend payout with cash reserves.
A company such as Apple has an insane amount of spare cash available for tough periods. If a company has barely anything in the bank and sees its revenue take a beating, you may find the dividend payout reduced or temporarily cut. And because we’re wanting to build a stable passive income portfolio, this simply will not do.
Debt is bad. For people and usually for business. You’ll want to go with stocks that have little to no debt. Even if the company is more than capable of paying off its debt in but a few years, it’s better not to put forward your money into risky investments that could see the company struggle.
Debt does allow companies to grow, but if they’re unable to meet payments and fold on the said commitments, things can quickly spiral out of control.
Healthy Payout ratio
Unless you’re investing in a REIT like Realty Income where a higher payout ratio is expected since most of its revenue should be going to shareholders, you’ll want the payout ratio as low as possible. This ratio represents how much of the company’s earnings are transferred to shareholders.
A payout ratio of beyond 100% simply means the dividends are unstable. The company will not be able to cover the said payments to shareholders without borrowing money.
Companies with a conservative dividend, which is increased each year are a safer bet. Not only do we want to have companies share their revenue with us, but also increase the amount paid annually. It’s also important for the dividend to grow alongside or more than inflation. If the dividend gets cut or you likely won’t see much in the form of an increase, the purchasing power will likely take a hit.
What’s the “dividend trap”?
The term “dividend trap” refers to stocks that may look appealing to an inexperienced investor, but are a risky purchase in reality. By only looking at the dividend yield of a stock, it can be extremely easy to invest in stocks that not only underperform but can cut dividend payouts.
Don’t fall into this trap. A dividend yield of 5% and beyond can (and usually is) too good to be true. The goal with a passive income portfolio is to regularly receive payments from companies for holding shares. In order to do that, we need to be investing in stable companies that can maintain dividend pay outs.