Strong Cash, Low Earnings Expectations
When vetting dividend-paying companies, long-term profitability is a key consideration. Although any company can occasionally experience a profitable quarter, only those that have demonstrated consistent growth on an annual basis should make the cut. Specifically, investors should seek companies whose long-term earnings growth expectations range between 5% and 15%. But beware: companies whose growth exceeds 15% tend to experience earnings disappointments, which almost always nick the stock price.
Next, investors should strive to find companies with healthy cash flow generation, which is needed to pay for those dividends.
Finally, a minimal five-year track record of strong dividend payouts signals continued dividend growth. Of course, it's essential for investors to purchase their shares prior to the ex-dividend date.
Steer Away from Debt
Investors should avoid dividend-paying companies that are saddled with excessive debt. Simply put: companies with debt tend to channel their funds to paying it off rather than committing that capital to their dividend payment programs. For this reason, it's imperative that investors examine a company's debt-to-equity ratio. If that figure sits north of 2.00, move on.
Check Sector Trends
While scrutinizing a company's numbers is key, it's no less essential to look at the broader sector, to cultivate a more holistic projection of future performance. Case in point: an oil company may be thriving, but a plunge in oil prices is likely to spike demand while decreasing supply. This may result in stock price depreciation and decreased dividend payouts.
For another example, look no further than the aging baby boomer population, which will inevitably skyrocket the demand for healthcare services over the next several decades. Although this doesn’t guarantee the performance of any single healthcare provider, generally speaking, healthcare stocks are resilient enough to weather broader market plunges. This paves the way for steady dividend increases moving forward.
Be mindful of the fact that a sector's behavior may change over time. For example, while investing in the soft drink industry has historically been a safe bet, consumers are becoming increasingly health-conscious. Consequently, most major beverage companies are migrating to the healthier/alternative drink space. But this shift will take time. Investors should recognize this before committing their hard-earned dollars to beverage company names.
The Bottom Line
If you plan to invest in dividend stocks, look for companies that boast long-term expected earnings growth between 5% and 15%, strong cash flows, low debt-to-equity ratios, and industrial strength.
