Investors looking to create a steady source of income with a lower risk appetite prefer stocks that pay dividends- the sum a company pays to its shareholders, as a gesture of goodwill for holding an equity in the business. Certainly the prospects of getting a steady income from the stock market holds a high appeal especially in times of market volatility and even otherwise. However, many times novice investors make the mistake of focussing solely on dividends as a stock selection metric ignoring other vital aspects. Let’s see what these aspects are and how to factor them in your stock selection strategy:-
While its extremely important to know about the company and the sector it operates in, it becomes all the more important if the company belongs to a volatile sector,for instance, sectors highly dependent on regulatory compliance, such as energy and pharma. These are a few sectors where a single piece of news becomes a tipping point for the fluctuation of the industry, eventually affecting the dividend payouts. So be very thoroughly sure of the company you opt for knowing very well about the sector and associated risks . Make sure you select a company that is fundamentally strong, has a robust corporate governance framework , is sustainable and holds high regulatory and compliance standards..
If a company is paying good dividend payouts despite high debt, then it is a red flag to watch out for. Many companies pay dividends using debt just to keep their stocks valuable. Debt is an extremely important indicator of a company’s financial health. Take a look at the debt-market cap ratio. The lesser this ratio is, the more stable a company is. If this number is increasing or hasn’t reduced over a period of time, understand that the company may not be a good bet, despite the high dividend payout. In the long run, debt impacts the growth prospects , affecting profits and in turn dividends.
A consistent payout is a sign of a healthy company. This means the company is constantly growing , is well managed and has a long term stability. Even if the dividends increase by a small number every year, the compounding effect can make the earnings pronounced as time goes by. So see the history of payouts and how it has been growing over the years.
It is natural to get attracted to stocks with a high dividend yield. However, a high dividend yield can be misleading at times. A high dividend yield may be a result of an underperforming security and hence is of no use if your capital base is depreciating. So don’t base your decisions solely on high dividend yield. Make sure your analysis is holistic, check the consistency of dividends and the overall stability of the company.
Payout ratio indicates the company’s capacity to support dividend payouts. Mathematically, it is calculated by dividing the dividend per share by the companies earnings per share. Consequently, the ratio of more than 1 indicates that the company is giving more dividends than it’s earnings and this poses a question at the company’s long term stability and hence its ability to pay dividends consistently.
While selecting dividend stocks, don’t base your decisions only on high dividend payouts.This is important because, many companies may not actually deliver when it comes to operations or profits and high dividends could just be a bait to engage the shareholders. So, scrutinise a company’s annual reports and factor in the consistency of dividend payouts, fundamental soundness, earnings growth, profits etc to carry out a holistic analysis of the company before taking a decision.
Disclaimer: The views expressed in this post are that of the author and not those of Groww.