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Robert Abbott
Robert Abbott
Articles (686)  | Author's Website |

Dividend Investing: 6 Considerations

Choosing stocks because they pay dividends is not a workable strategy—consider these 6 factors that will influence success or failure

September 24, 2019

Before buying a dividend stock, Mark Lowe explained in “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” you need to consider these six factors:

  1. Dividend yield.
  2. Profit growth rate.
  3. Balance sheet.
  4. Debt volume.
  5. Sales performance.
  6. Prevailing tax laws regarding dividends.

Dividend yield

In this consideration, Lowe said the act of paying dividends indicates a company’s financial condition is good. The dividend yield will tell us how good, and how much dividend income is being generated. For example, if you pay $50 for a stock that pays a $5 dividend, then the dividend yield is 2.5%.

But he recommended we not use dividend yield by itself because companies may continue to issue dividends even though their profits are falling, or they may pay high dividends when they should be retaining some earnings to reinvest.

To guard again such situations, look at the total profit as well as the dividend yield. The former will tell us whether the dividend yield is sustainable, especially when investing for the long term.

Lowe also introduced an associated term, "relative dividend yield strategy.” This involves comparing the yield of a specific stock to the yield of the full sector, allowing investors to potentially discover undervalued opportunities (higher yields are the clue).

Profit growth rate

What is the trend in the company’s earnings? Start with the revenue growth, the way sales are headed, and follow up with net profit, which is what is left after all expenses have been paid. Next, turn to the earnings per share, which will be affected by both the net profit and the number of shares outstanding.

Obviously, a company with rising revenue, net profit and earnings per share is more likely to be able to increase its dividends in coming years.

Balance sheet

The balance sheet is one of three documents found in a company’s financial statements; the others are the income statement and the cash flow statement. Within the balance sheet, you will find the levels of assets and liabilities over a specific period, usually a year.

When examining the assets, distinguish between current and non-current assets (current assets can be converted to cash within one year). Current assets will include cash on hand and investors should have a sense of whether the amount of cash is too high or too low for the type of business.

Liabilities, too, are divided into current and non-current varieties. Debt is usually the most important liability, whether short term or long term. Companies that carry a relatively high debt load, compared to other companies in that sector, should be viewed with suspicion.

Equity is the third number of interest on the balance sheet; it is calculated by subtracting liabilities from assets. Within this section, scrutinize the amount of retained profits and paid-in capital (the amount invested by shareholders).

Debt volume

In the section above, we briefly mentioned debt, a liability that can be found on the balance sheet. Start by considering the volume of debt: Can the company handle it given its revenues and profits?

The type of debt also makes a difference because there are short-term and long-term loans, and there are bank loans and lines of credit versus fixed-income instruments such as bonds. The type of debt can be of significance.

Check, too, on the purpose of the debt. Lowe put it this way: “Why is the company applying for a loan in the first place? Would the company use the fund for a new project with high potential for income generation? Is the company in a bad financial situation that it has to take loans to pay its staff wages or consolidate debts?”

Sales performance

To quantitatively assess the sales performance of a company, use the price-sales ratio (calculated by dividing market capitalization by gross revenue over the past year).

A company with a low price-sales ratio, compared with its peers in the same sector, is usually a better buy than one with a higher ratio. That’s because the stock is more likely undervalued.

According to the author, “Low Price-Sales Ratio may signify unrealized potential in value as long as other metrics are confirmed such as high-profit margins, low debt volume, and high growth prospects. If you only rely on Price-Sales Ratio alone, you cannot say that you properly valued the company you are interested in dividend investing.”

Tax laws affecting dividend investments

Much of Lowe’s discussion of this subject revolved around an American tax change, the Jobs and Growth Tax Relief Reconciliation Act of 2003. It was designed to reverse the declining number of companies paying dividends by reducing the tax rate on dividends to 15% from 28%. It also reduced the rate on long-term capital gains for individual taxpayers to 15%.

Also noted is that individuals receiving dividends are taxed twice. First, the corporate income tax takes a slice off the top, and then individuals receiving dividends pay again when they file their personal taxes.

Every individual investor will have a somewhat unique tax situation because of both personal and investment decisions. Lowe wrote, “As an investor, you must be careful in placing your investments in a position where you are only expecting an income stream that might be substantially affected because of certain legislations.”

Conclusion

Six factors should be carefully considered by investors planning to buy dividend stocks. Lowe, in “Dividend Investing: Simplified - The Step-by-Step Guide to Make Money and Create Passive Income in the Stock Market with Dividend Stocks,” argued:

“It is not enough to choose stocks of companies because they have a record of paying dividends to their shareholders.

You also need to take a closer look at other metrics such as profit growth rate, balance sheet status, debt volume, sales performance, and prevailing tax laws that could affect your capital gains and dividend payouts.

Assessing certain dividend stocks against these metrics will ensure that you are investing in high-potential instruments.”

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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