How to pick the best dividend stocks

Dividend investment is an effective method of wealth accumulation that provides inflation protection in a way that bonds do not. But finding first-class dividend-paying companies can be a challenge. This article highlights the main factors that investors should pay attention to when looking for valuable dividend stocks.

Key points

  • Dividend investment is a reliable method of wealth accumulation that can provide functions not available in inflation-protected bonds.
  • Dividend investors should look for companies with long-term profitability and earnings growth expectations between 5% and 15%.
  • The company should brag about the cash flow needed to support its dividend payment plan.
  • Investors should avoid companies with debt-to-equity ratios higher than 2.00.
  • In addition to studying the fundamentals of specific companies, investors should also educate themselves on broader industry trends to ensure that the company of their choice can thrive.

Abundant cash, low earnings expectations

When reviewing dividend companies, long-term profitability is a key consideration. Although any company will occasionally experience a profitable quarter, only those companies that show continued growth each year can advance. Specifically, investors should look for companies with long-term earnings growth expectations between 5% and 15%. But be warned: companies that grow more than 15% tend to experience disappointing earnings, which almost always affect stock prices.

Next, investors should work hard to find companies with healthy cash flows that need to pay these dividends.

Finally, the minimum five-year record of strong dividend payments indicates continued dividend growth. Of course, investors must buy their shares before the ex-dividend date.

Stay away from debt

Investors should avoid dividend-paying companies with too much debt. In short: Indebted companies tend to use their funds to repay debt, rather than investing these funds in dividend payment plans. For this reason, investors must check the company’s debt-to-equity ratio. If the number is north of 2.00, move on.

View industry trends

Although reviewing the company’s numbers is key, it is equally important to look at the broader industry and make a more comprehensive forecast of future performance. To give an example: an oil company may be booming, but a plunge in oil prices may stimulate demand while reducing supply. This may result in a depreciation of stock prices and a reduction in dividends.

To give another example, look at the aging population of baby boomers, which will inevitably soar the demand for medical services in the coming decades. Although this does not guarantee the performance of any single healthcare provider, in general, healthcare stocks are resilient enough to withstand the market’s collapse. This paved the way for a steady increase in dividends.

Note the fact that the behavior of an industry may change over time. For example, although investing in the soft drink industry has always been a safe bet, consumers are increasingly focusing on health. As a result, most major beverage companies are migrating to healthier/alternative beverages. But this transition will take time. Investors should realize this before putting their hard-earned money into the name of a beverage company.

Bottom line

If you plan to invest in dividend stocks, look for companies with long-term expected earnings growth of 5% to 15%, strong cash flow, low debt-to-equity ratio, and industry strength.

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