Dividend investing explained: How to pick dividend stocks?
Dividend investing is a popular approach used by investors looking for lower-risk investments with predictable income over time. However, this investment strategy, like many others, has its own pitfalls and can be risky if you don't get to know which stocks to avoid.
Let us understand the reason why investment strategy is popular among retail investors and how one can pick such stocks to add to their portfolio.
In simple terms, dividend investing is a strategy of buying dividend stocks to generate wealth by reinvesting their dividends back into similar stocks. By doing so, investors get two sources of potential profits, namely, the predictable income from dividend payments disbursed by companies and capital appreciation of the stocks over time. This is especially appealing to those investors looking to invest without undertaking substantial risk.
How does it work?
We can understand this strategy with the help of an example. Let’s say, you buy 100 shares of a company with a stock price of Rs 500 with each share paying a dividend of Rs 15. You would have invested Rs 50,000 and over the course of a year, you would receive Rs 1,500 in dividend payments. That works out to a 3 per cent yield. Now you have options to choose what to do with your dividend. You can reinvest them to buy more shares of the company or buy stocks of a different company, save the cash or you could just spend the money.
Regardless of the movement in the stock price, you will still receive those dividend payments as long as the company continues to disburse them. This is the appeal of buying stocks with dividends - it can help cushion declines in the actual stock prices but also, presents an opportunity for stock price appreciation coupled with a steady stream of income from dividends.
However, not every company can maintain a steady dividend payout during an unsteady economic environment as we have witnessed during the COVID-19 pandemic. And so, it is important to have a diversified portfolio of dividend stocks that will help you get reliably paid, no matter what!
Key metrics for dividend stocks
Before you go on to buy dividend stocks for your portfolio, it is important to understand the ways to evaluate them. Some of the metrics listed below can help you understand how much income you can expect to receive via dividends and how reliable the dividend may be.
Dividend yield: Simply put, the dividend yield of the company is the annualised dividend disbursed represented as a percentage of the stock price. Like we have seen earlier, if a company pays a dividend of Rs 15 and the stock costs Rs 500, the dividend yield would be 3 per cent. A higher-dividend yield is better, but a company's ability to maintain the dividend payout and ideally increase it, matters even more.
Dividend payout ratio: The dividend payout ratio is a percentage of the company’s earnings it chooses to pay out in dividends. If a company has an EPS of Rs 30 and pays out Rs 15 in dividends to equity shareholders, then the dividend payout is 50 per cent. It is more important that this payout ratio, which is sustainable over time.
Free cash flow to equity (FCFE): The FCFE ratio measures the amount that could be paid out to equity shareholders after all other expenses & debts have been paid. It is calculated by subtracting net capital expenditures, debt payments, and change in working capital from net income, and then adding net debt. Typically, an investor would want dividend payments only, being paid in full by FCFE.
Total return: This is the return taking into account capital appreciation and dividends. For example, if you pay Rs 500 for a stock that increases in value by Rs 100 while earning Rs 15 in dividends, then the total return is 23 per cent.
High yield isn't everything!
It's important for investors to keep in mind that higher dividend yields do not always indicate attractive investment opportunities because the dividend yield of a stock may be elevated as the result of a declining stock price, also known as a dividend yield trap. Often stocks that have an unusually high dividend yield than their peers are a sign of trouble, not opportunity.
It is better to buy a dividend stock with a lower yield that is rock solid than to chase a high yield that may prove illusionary. Focussing on dividend growth, the company's history and ability to raise its stock dividend often prove to be more profitable.