This article is sponsored by Securities Commission Malaysia, under its InvestSmart initiative
Dividend-paying stocks play an active role in a long term investment portfolio because they may provide a somewhat predictable stream of income, can be used as a potential indicator of capital appreciation and is a key diversification method for weathering portfolio volatility.
Here are the factors you should consider when deciding which dividend-paying stocks would work best in your favour:
1. The higher the dividend yield, the better
The dividend yield of a stock depends on your purchase price. If your stock’s price rises after a dividend announcement, the dividend yield will drop.
You can find out the dividend yield of a stock just by reading the company’s past annual reports. You can also calculate the dividend yield ratio by dividing the total dividend of the financial year (not calendar year) by your buying price.
2. Mid- and large- cap stocks
Lookout for stocks offered by large, mature companies capable of providing stable revenue, profits and cash flow, as they are typically considered the best dividend-paying stocks. These companies are no longer expanding aggressively; therefore the majority of their earnings are distributed to investors in the form of dividends.
On the other hand, a small, high-growth company may require more financial resources to grow and expand their business. They tend to not distribute gains to their shareholders, instead using them to reinvest into the company to boost growth.
3. Ability to be consistent in paying out dividends
The company you intend to invest in should have a long and stable track record of paying dividends. It would not be too beneficial for you as an investor if the company is large and successful, but only makes sporadic dividend payments to their investors.
The best way to decide if the dividend-paying stock is worth your while is to check if the company issuing has been paying consistent, growing dividends to its investors over a period of at least five to 10 years.
If you want your investments to be a stable source of income, then focus on and invest in companies that are stable enough to finance their growth without compromising on dividend policy.
4. Sustainable and strong company fundamentals
A company’s historical data is important, but it will never guarantee that the company will always perform as it has in the past. Besides the dividend yield and consistency of dividend distribution, investors should also look into the overall aspects of the company’s fundamentals and ensure that they are healthy.
Even if a company has a consistent dividend pay-out policy, deteriorating fundamentals such as declining revenue, reduced profits and inconsistent cash flow may affect its ability to sustain its dividend pay-outs in the long term.
The less revenue or profit a company makes, the less dividends you will receive. Companies with weak fundamentals may also see their stock price affected as investors may no longer find it financially attractive. A fall in stock value will then eat into any dividend gains you might have had in the beginning.
Therefore, always make sure that the company you want to invest in is fundamentally and sustainably strong, robust and will continue to do so for many years to come.
5. Low capital expenditure
To reasonably foresee if the stocks you are buying will be able to deliver the dividends that you are expecting, it pays to look into the company’s capital expenditure (CAPEX).
A company with a high CAPEX indicates that it is in a growth stage and has been continually reinvesting its profits back into its business instead of distributing them as dividends to its investors.
On the other hand, if a company has a low CAPEX, it could mean that it’s no longer looking at aggressive expansion and is unlikely to reinvest its earnings. Thus, they would be more likely to pay good dividends.
6. Stable cash flow
When it comes to evaluating cash flow, choose large, stable companies that produce high amounts of free cash flow annually.
Smaller companies that are still expanding may have negative or inconsistent cash flow, and hence, will not be able to consistently pay dividends to its investors.
Analyse the company’s balance sheet to determine the net cash or net debt position of the company. This figure will give you a rough idea of how long the company can maintain its dividend pay-out even when cash inflow is low or negative.
Conclusion: Always do your homework!
As investors, we all love earning dividends. Besides the thrill of watching your stocks rise higher in value, you equally look forward to receiving passive income in the form of dividends from your investments every year.
We must always scrutinise the companies we are looking to invest in based on our objectives. If you are focused on dividends and it looks like your stocks are not meeting a few of the points above, do not hesitate to invest in different stocks or sectors. Remember, investing for dividends is a long term game filled with changes, volatility and the need for constant diversification!