As you probably know, I consider myself a dividend investor since I tend to invest only in stocks that pay dividends.
Related: 5 Advantages of Dividend Stocks
I personally believe the markets go through short term ups and downs, but dividends are what provide real returns for investors over the long term. I can’t predict what the markets will do in the short term, but I’d like to have the ability to rely on dividends for the long term.
I tend to focus on both capital appreciation and income (through a dividend). I don’t have a defined benefit contribution plan, so when I retire, I’ll need the income that dividend stocks generate.
Here are a few basic criteria that investors use to screen and select dividend stocks.
The ‘Price to Earnings’ ratio is the current price of the share divided by the company’s earnings per share. A higher P/E ratio means that investors expect higher earnings growth in the future. It shows how much an investor is willing to pay for the stock for every one dollar that the company earns. When comparing P/E ratios, it is important to note two things:
(1) P/E ratios are usually industry-specific and one company should be compared to others in the same industry and
(2) the ratio relies on accounting earnings per share, which in itself may not be a true reflection on where the company is headed in the future.
Bottom line: a potential investor shouldn’t rely only on this ratio when deciding whether to buy or not.
Current Dividend Yield
This is the amount of annual dividends divided by the current share price. If a company pays $1 in dividends per year and it is currently trading at $10/share, the current dividend yield is 10%.
This is important when determining the amount of dividends to be received from a company. Assuming dividends remain steady, dividend yield will decrease if a stock goes up in price and increase if a stock goes down.
Earnings Per Share
Earnings Per Share (EPS) is the indicator of a company’s profitability. It is the net income (less dividends) divided by the average outstanding shares of a company. Although this relies on accounting net income, it is very important when considering an investment. A higher EPS generally means a company is more favorable. One thing to note is that ‘net income’ is often subject to complex accounting rules and companies are under pressure (from shareholders) to make it look as good as possible. Companies will do whatever they can within the rules to maximize net income as analysts use it to rate companies.
Dividend Payout Ratio
This ratio is the dividends paid per share divided by the earnings per share. It shows the percentage of earnings that are paid out in dividends. If a company pays out over 100% of earnings in dividends, the dividend may not be sustainable in the long term. An acceptable ratio depends on the industry, but consecutive losses and steady dividends may mean the dividend will be cut in the future
Dividends paid per share – this number is used to calculate the dividend payout ratio (see above)
To find quality dividend stocks using ratio analysis, I prefer to use the Google Stock Screener on Google Finance. The screener allows you to tailor your search using specific ratios. I usually include the P/E ratio, dividend yield, EPS and dividends per share.
Then I copy the data over to an excel spreadsheet and can easily determine the dividend payout ratio. The dividend payout ratio is simply the dividends per share divided by the earnings per share, and should be shown as a percentage.
Conclusion – there are tons of ways you can evaluate dividend stocks – the above are a few common ones. For my money I tend to focus on a solid history of paying dividends, a decent yield that is also sustainable and long term growth potential.
What do you use to evaluate stocks when investing?