I love the idea of passive income. I work full time. I have been working full time for the last 11 years. And, there is barely any time left to pick up a side hustle. In 2014, I started wondering, what should I do to plan for retirement? And I picked up a few books. I have been researching ever since. I loved the idea of dividends. Someone else does the job and I get paid for owning a piece of a company.
S0, How to identify the best dividend paying stocks? You may get surprised to find out, often times the highest yielding stocks are the worst ones. You need to pick up great businesses. Which generate a lot of free cash flow, Low in debt. And, you would like to see your company grow too, so why not buy a business that has growth left? You can use screeners like finviz or screener.in to find out the stocks, as long as you know what search parameters to use.
The company Game Stop was yielding over 8% in June 2019 and the management came out and said they are not going to pay anymore dividend anymore, the stock crashed. Game Stop is not alone, this happens to many companies. Hence this post, to educate you hot to choose a company for dividend income. GE investors got a pay cut when the dividend dropped to 1 cent per share
Why you should not look for the highest yielding stocks?
Highest yielding stocks are often yielding so high because the stock price has crashed. And you need to find out, why the stock price crashed so much. Was it a temporary setback or a long term trend? Let us take the example of Game Stop.
Game Stop is a brick and mortar store with an ancient business model. They sell gaming consoles, DVDs accessories, etc. Now when is the last time you visited a Game Stop store? Do me a favor, find the local Game Stop store and check out the crowd or footfall that store is getting. And without checking any financial you will get an idea why they are cutting their dividends. Their revenue is tanking, if they payout their retained earnings, they won’t be able to pay down their debt.
As the owner of the stocks, you are part-owner of the company. As a part-owner, you would want your company to survive and thrive for a long time. So, paying off debt might look like a good move. But, if you are an income investor, who just lost a dividend check, will you be pleased?
GE had a similar problem. It has so much debt that it does not what to do with it. I mean, they know they will have to pay it down. But they do not have enough cash flow to continue paying a dividend and the debt. So, they had to cut down a dividend, save money there, and then use that saved cash to pay off debt.
How do I know how to identify the best dividend paying stocks? I have been investing since March 2008 and my share of mistakes. My goal is to help you not make the same mistakes I made. All you need to do is to read what I write and ask me questions when you have any. I might not know everything, but by asking questions you will find out what I know.
How to identify the best dividend paying stocks?
You can use stock screeners such as finviz.com or screener.in. Create a filter and find out the highest yielding dividend stocks. In case you are wondering what a dividend yield is here is the answer. Say you buy a stock worth $100 or 100 rs. End of the year the stock gave you $2 or 2rs dividend. The stock price is unchanged. You dividend yield is 2%. In case your stock price is $50, in that case, the dividend yield is 4%. In case your stock price is 200rs, your dividend yield is 1%. I hope you got the idea.
Now here is what you go to do –
In the screener set Return on Equity > 15%
Return on Investment > 20%
Debt to Equity < 50%
Dividend Yield> 3%
Chances are you will not find many options to invest in. Because often the utility companies and the mining companies are best dividend payer. I almost forgot the oil and gas companies. But they are often established and heavy Capex (capital expenditure) company and do not have a great return on equity or return on investment.
But make sure your company does not have a lot of debt and generate at least 10% on equity. I am sure you can find some. In case you do not know what a return on equity is or what return on capital/investment is please let me know, I will explain.
For now, return on equity and return on capital shows if the management is any good with capital allocation. And how much return they generate on their project investments. Debt to equity will tell you, how well the management has managed the debt. Will they be able to comfortably make bond payments in the future? These are very important for a financially fit company. You can select the dividend yield to be anything. 3% is just an example.
Why the business defines the longevity of dividend?
In case you already have some dividend-paying stock, let us know what you have. And in case you are wondering why I am stressing on low debt and good return on equity, I want you to own something that does not have a lot of debt and can service their debt comfortably. And can generate a good return on investment. If you find something in utilities, oil, and gas or in the mining sector, you can rest assured that the company has some life left. REITs can be a good option too.
But in the age of eCommerce, not all REITs are equal and safe. Ideally, your company should have a long runway. Visibility in earning. The capability of servicing debt during a downturn. Hopefully, it generates some return too, so the stock price goes up eventually.
I hope we are clear that the best dividend paying stocks are good stocks first and they pay dividend too. Just having a high dividend yield does not mean it is good business. Or that business has any future prospect. Or the business will survive an economic downturn. And if the company is a zombie company, with no growth prospect the price of the company will go down causing you a notional loss on holding price.
Hence, doing homework on analyzing financial health, management, and future growth prospect is very important to incase of finding the best dividend paying stocks. You got some idea on doing it too. I will say it again, do not chase yield or you might burn your hand, chase a good company that has good dividend yield. Now you know which sector to look at. Always wait for the stock price to fall. Once it goes down, buy it as much as possible.
What is a Dividend?
I am going to talk about publicly traded companies only. I never made any investment in private companies. Say you purchase the stock of Apple computers or TCS in India. You own part of this business. Yes, it might sound weird, but legally you are part owner. You have rights on part of the earning company makes. At the end of the financial year, whatever free cash flow the company makes, the management decides what to do with the cash. They can decide to retain it and maybe they will expand their capacity in future or do an acquisition.
Or they might not have any idea and can simply return the money to investors. They can return the cash to investors in the form of buyback or dividend. We won’t talk about buyback here in this post. The cash you get in your brokerage account or bank account for owning the share is known as a dividend. And you have a little bit of context where that cash is coming from.
Why does the price of stock drop right after the Ex-Dividend?
I will give you a small example. Say we have a company that has a total asset worth $900 and $100 in cash. There is no outstanding debt or liabilities. And out of this $100 cash, the company decides to pay $50 as a dividend. Now the company will have $900 in net assets and $50 in net cash. That brings down the valuation to $950, hence the stock price drops.
Paying out dividend might not be the best use for a firm. But, that depends. Matured firms often prefer to reward investors that invest cash in nonrelated businesses.
Do you already own any income stock? How did you select it? After reading this post how do you feel about your selection process?