What is a dividend yield trap? A dividend yield trap is when an investor seeks a high dividend yield company, but the increase of the dividend yield could be due to the increase in dividend payout or the decrease in stock price. If the stock price decreases due to some fundamental issue with the underlying business, then the investor could be investing in an underperforming company.
So the key to building a solid dividend investment plan is to only buy stocks that meet certain investment criteria. Here are the 9 Main Criteria For Picking Dividend Stocks :
Criteria 1 : Strong Cash Flow
A company with strong cash flow allows it to scale its operations and develop new products to stay competitive in business. It also provides the company the support to fund dividend payout which means investor will receive more dividends in return.
Check the company's history of Free Cash Flow if it is positive and growing year by year. Search for companies with a Free Cash Flow Yield (FCF Yield) of at least 5%. FCF Yield is a financial solvency ratio that compares the free cash flow per share a company is expected to earn against its market value per share. The ratio is calculated by taking the free cash flow per share divided by the current share price. Besides FCF Yield, the company should also have a positive and increasing cash flow from operating activities (Operating Cash Flow).Look for a company that has at least 5% growth on Net Income for 3-5 Years. A stable company with strong cash flow should have growing Net Income, Free Cash Flow Yield and Operating Cash Flow for the past 5 years.
Criteria 2 : Check Its Cash and Cash Equivalents
A growing level of Cash and Cash Equivalents usually shows that the company has strong financial performance. It indicates how solvent and reliable is the company's financial strength and its ability to stay strong during any financial crisis.
These type of companies tend to buy back their stocks and perform share re-purchase. Look for companies with consistent growth in Cash and Cash Equivalents for the past 5 years. You can find this information in the company's Annual Report under Balance Sheet.
Criteria 3 : Debt Repayment
A well managed business is able to keep its debts low and manage any of its debts effectively. However a company with high debt and decreasing income may start to cut into dividends to prioritize its debt repayment.
One ratio which we can use to evaluate whether a company has a a good chance of settling its debt is the Debt Coverage Ratio.
The Net Income should be at least 3 times of the Total Debt Service. Look for companies with a Debt Coverage Ratio of 3:1. Total Debt Service can be the Interest Expenses (you can find this in Income Statement) and other payments (eg: lease payments, interest, sinking fund, principal).
Lets take Coke (Ticker Symbol KO) as an example.
KO's Net Income $8,920 million is more than 3 times higher than Interest Expenses at $47 million. This shows that KO can easily pay its annual interest expenses with the income it generates from its operating activities.
Criteria 4 : Regular and Reliable Dividend Growth Rate
Invest in companies that have shown a strong history of regular and consistent dividend growth. Check out the company's dividend policy to see how frequent it pays out its dividends in a year (ignore Special Dividends as they tend to be special case and one-off).
Look for companies with a long term Dividend Growth Rate of at least 5% per year.
Criteria 5 : Existing Dividend Yield
Look for high growth companies with a current Dividend Yield of at least 5%.
A company can have a high dividend yield but if it is a low growth company, it may not have the ability to consistently grow its dividend. So look for a company that has at least 5% Dividend Yield and is a mid to high growth company.
Criteria 6 : Dividend Payout Ratio
Look for a company with a dividend payout ratio somewhere in between 30% to 70%. With a payout ratio of 70%, the remaining 30% can be used for the company's future growth. Companies with too high payout ratio usually do not have much room for growth and may have issues growing their dividends in the future. I have even seen companies with a dividend payout ratio of over 100% which can be a clear warning sign and requires a detailed analysis to see why it can have such high ratio.
The same goes for companies with too low payout ratio as they may have a hard time to grow and pay out dividends over the long run.
Criteria 7 : Return on Equity
Look for companies with strong Return of Equity (ROE). Return On Equity is the percentage return you get as a shareholder from the equity in the business. If you’re looking for potential dividend growth, focus on companies with an average of 12% ROE for the past 5 Years.
Criteria 8 : Evaluate Performance of Management Board
A strong management team with a good record of strong business performance and improved financial status will usually award their investors handsomely through dividends and capital appreciation. You can evaluate the performance of the company's management board by reading the company's annual reports. You can find the company's long term growth and expansion plans in the annual reports.
Criteria 9: Strong Insider Buying
Check what the company's insiders (Founder, CEO, Directors) are doing with their own stocks. See if they are heavily selling or buying more shares. If they are selling a large number of shares, this may raise a red flag indicating that the company may be heading for tough times ahead or the price of the stock may be overvalued.
To be successful in your dividend investment, have a strong dividend investment plan and to invest a certain percentage (can be monthly, quarterly, semi-annually) into good dividend stocks. The earlier you start, the better due to magic of compounding interest.
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