Investing in dividend stocks is a great way to make a passive income, but how does one choose which stocks to invest in? Half the battle is in knowing what to look for, and we’ll try to cover the basics of that here.

Yield

If you’re investing in dividend paying stocks, the first thing you are going to look at when considering a particular company’s stock is its dividend yield. Annual yield can be calculated by taking the annual dividend (for example, if the dividend is paid quarterly you multiply it by four to get your annual dividend) then divide it by the current share price. Take this figure and multiply it by 100 to give you a yield in percentage terms. A stocks annual dividend yield can be thought of as how much you earn every year for each $100 you have invested in that stock. For example, if a stock has a yield of 5%, you will receive $5 a year for every $100 you have invested in that stock.

Ideally you should be looking at stocks with a moderately high yield, since too low of a yield would not be enough return for your portfolio, yet if a company offers a very high yield it may be a sign that they are a high risk investment. A yield of 4 to 6% annually would be considered a decent dividend yield. Anything less than 4% and it would be safer to put your money in a bank CD, and anything higher than 7% is abnormally high and may suggest a high-risk equity or a low share price, and will need further investigation. Sometimes some companies do offer large dividends without being high risk, but make sure you do your research carefully regarding the background of the stock.

Retained Profit

You should check the level of the company’s total profit that is being paid out to shareholders, if the level is above 40 or 50%, they are giving away too much and not retaining enough of their profit to reinvest back into the business. Reinvesting their profits allows a company to grow their business even more, hopefully resulting in dividend increases on a regular basis. It has been claimed that if some of the financial institutions caught up in the 2007-2009 financial crisis had a lower dividend payout ratio (i.e. they paid less dividends to shareholders and reinvested more into the company) they would have avoided the majority of the problems they faced over the two year period – bear that in mind!

Dividend Payout Frequency

Most stocks will pay out dividends to their shareholders every quarter, but some stocks pay their dividends monthly, and a rare few pay semi-annually or even annually. Monthly dividends are the best in the long term as they allow you to reinvest back into the stock and grow your dividend income at a slightly faster rate. With stocks that pay a quarterly dividend, you are effectively wasting three months of extra growth which would have come from the extra shares you reinvest the monthly dividends in; it is only a few basis points, but in the long run it is well worth it. For a more detailed explanation of why monthly dividends are better than quarterly see please see our previous article. However, one important point to consider is that you shouldn’t sacrifice a high yielding stock because a lower-yielding stock offers more frequent dividend payouts, as you will only squeeze an extra few basis points out of your total income for having monthly dividends.

Earnings History, Debt and Return on Equity

When picking dividend stocks, you should look for shares that have a good solid earnings history, with little or no debt, and a good return on equity. Past earnings are a good indicator of the stability of the company, and forecasted earnings (usually available in the shareholders’ report available on the company website, or by written request) will outline what the company hopes to make over the next few years. Here you should look for solid growth in earnings as this is usually linked to an increase in dividends. A company with no debt is the most stable company you could hope to invest in as a dividend investor, since will not have to worry about them paying off their debt out of potential dividend earnings or going into administration under the burden of debt. In reality, most companies do have some level of debt, so simply look for companies which have the least debt, or the least debt in relation to the equity of the company (the debt-to-equity ratio).

Another interesting ratio to look at is the return-on-equity ratio. Some companies are very capital intensive, and need a large amount of cash to make a certain return, whilst other companies are the opposite of this and need a much lower amount of cash to make the same return. If possible, you should choose a firm that can generate returns with a low amount of equity as they are less likely to have debt concerns, and will survive better in a recession.

Dividend Increase History

Some stocks have earned the title of ‘Dividend Aristocrats’ or ‘Dividend Achievers’ for increasing their dividends for a certain number of years in a row. Dividend Achievers are firms that have increased their dividends for the past ten consecutive years, whereas Dividend Aristocrats are the very elite firms which have increased their dividends for the past 25 consecutive years and are added to an index of Dividend Aristocrats run by Standard and Poor’s. Some Dividend Aristocrats have even increased their dividends for over 50 consecutive years.

The advantage of investing a firm with a long line of dividend increases is that they are more likely to continue increasing their dividends annually to remain on the elite indices so you can continue to grow your income year after year.

Conclusion

The measures listed above should help you pick out some good dividend stocks to invest in for a good passive income. One important piece of advice is to look at the stability of each company as a high (if not the top) priority. It’s okay investing in a company with a high yield, but if that high yield is at the cost of a large negative capital growth you should avoid their shares at all cost; for example, if a company’s dividend is yielding a 20% return, but the company will be bankrupt in three years you will have lost all of your initial investment and end up with a net loss, if you invest in their shares. So make sure to do thorough research and have fun building your dividend income portfolio.

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