Image Source: NASDAQ.com from the article What Is A Dividend? by Martin Tiller
It seems like we never make enough income to support ourselves or prepare us for retirement.
So, this begs the question, where do you find investments that pay you while you work?
Over the next month or so, I'm going to explore this topic in depth. The first area I'm going to explore are stocks which pay dividends.
Dividends are a form of income that entitles equity owners to a portion of the company's net income. Companies usually pay a dividend when they realize they can no longer grow their business at a rate of return which justifies a significant investment.
There are two types of dividends in equity investing: stock and cash. Stock dividends are just that, where the company pays you for additional shares of stock paid in fractional amounts. Very few companies I know of pay stock dividends.
The majority of publically traded companies nowadays, however, pay cash dividends. A cash dividend will come from one of two areas: either free cash flow and debt.
When a company pays cash dividends from free cash flow, this just means they have more cash that is freely available to pay to shareholders after paying for business operating and financial expenses.
Companies also employ debt to pay cash dividends. When companies issue bonds, they sometimes use the cash proceeds to pay dividends to shareholders. Examples of companies using this method would include real estate investment trusts (REIT) and utilities. The reason some companies use debt to pay cash dividends is that of the tax benefit associated with the interest expense from issuing bonds.
So how does someone know if a cash dividend is a sound payout? There are certain criteria I use to select good dividend paying stocks. Here they are:
1) Payout - This merely indicates the percentage of earnings per share paid to common stockholders in the form of cash dividends. I don't like to see a company pay more than 100% of their EPS in dividends. That to me is unsustainable. Preferably, I like companies whose dividend payout range is between 10% and 85%. The range I've listed above seems safe to me.
2) Dividend Coverage - This is a measure of the company's trailing twelve-month earnings divided by its indicated annual dividend (IAD). The higher this number is, the greater the likelihood a company can afford to raise its cash dividend. I like seeing companies cover their cash dividend at least 1.5x. The dividend coverage ratio of 1.5x or higher also seems safe to me.
3) Interest Coverage - This is a measure of net earnings before interest and taxes (EBIT) of one-quarter divided by interest expenses on bonds and other contractual long-term debt for the same period. The higher this number is, the less likely the company is burdened by debt expense. I like to see an Interest Coverage ratio of 1.70 or greater as this indicates to me that the business is generating sufficient sales revenue and earnings to cover their interest expense.
4) Free Cash Flow - The motherlode of cash dividends! Free Cash Flow is calculated from Operating Activities Net Cash Flow minus Capital Expenditures. So if free cash flow is less than a company's cash dividend payments, the company is likely borrowing to pay their cash dividends. The interest coverage ratio (see above) comes in handy to determine whether the company can afford to issue new debt and pay cash dividends on it. The more free cash flow a company generates above its cash dividend payments, and the higher the Interest Coverage ratio, the greater the possibility a company can sustain the cash dividend payment and...
5) Dividend Growth Rate - This is simply a way of measuring whether the company has grown or cut (!) their cash dividend. So long as this number is not below zero over a one and five-year time frame, this indicates to me that the company is very committed to paying its cash dividends to shareholders.
I won't tell you that my method is foolproof, but this process works for me.
So you probably are wondering where you can buy dividend-paying stocks?
There are one of three ways to do so. First, you can buy shares directly either on a stock exchange like the NYSE or NASDAQ, or you can buy shares directly from companies themselves using dividend reinvestment plans (Drips).
Another way is by buying exchange-traded funds (ETF's) that bundle dividend paying stocks into a liquid investment that trades on the stock exchange. ETF's have lower fees than traditional mutual funds and less risk than buying individual stocks. Ask your registered investment advisor about them.
Finally, you can buy index funds that pay a cash dividend without paying the higher fees of traditional mutual funds. Ask your registered investment advisor to see which index fund is suitable to your risk tolerance and investment objectives.
Thanks for reading @ellofinance today. I hope you found today's article educational and informative. Have a great weekend, and enjoy the beautiful weather outside!