What makes the ‘perfect’ dividend stock? Is there even such a thing? In my opinion, the key to dividend investing involves investing in companies that consistently increase their dividend payouts. This way, an investor can really capitalise on the power of compounding, reinvesting a higher amount each year. Furthermore, this strategy is likely to generate capital growth in the long term as the higher yields on offer push stock prices up over time.
To my mind, a perfect dividend stock is a company with an excellent dividend growth track record, and a certain set of characteristics that indicate that the dividend growth is likely to continue. Here’s what I look for in a dividend stock.
The perfect dividend stock
In the search for the ideal stock, a good starting place is the company’s current dividend yield. I generally look for a yield of between 4% and 5.5%. Anything less than 4% is a little underwhelming (especially as inflation creeps up) and anything higher than 5.5% is approaching a level that might be considered unsustainable. Next, I check the company’s recent dividend growth history. Ideally I like to see growth of 5% to 10% a year over the last half decade.
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To achieve this kind of return, a company generally has to be increasing its turnover and profitability so I look for both revenue and earnings rises of at least 5% a year in the same period.
To ensure dividend sustainability, I like to see a dividend coverage ratio of at least two. Furthermore, the company’s debt-to-equity ratio should be under 50%, as I don’t want a company that is burdened by large interest payments.
Lastly, the company should enjoy a fairly constant demand for its products, and should trade on a P/E ratio of 15 or less. That’s not asking too much, is it?
FTSE 100 screen
Well, when it comes to the FTSE 100 index at present, it is asking too much. Indeed, when a stock ‘screen’ with the criteria above is applied to the FTSE 100 index, it returns a grand total of zero stocks. There’s not a single company in the index that has those characteristics right now. So where does the dividend investor go from here?
Three options
I’ve got three main options. First, I could look at dividend opportunities outside the FTSE 100. However, when the same stock screen is applied to the UK market as a whole, it still returns zero stocks. Clearly, I’m being too fussy in the search for the perfect dividend stock.
Next, I could relax my criteria. For example, if I lower my required yield to 3.5% and my dividend cover to 1.5 times, five names show up across the UK market: easyJet, Bellway, Bovis Homes, Numis and Bloomsbury Publishing.
EasyJet and Bovis are forecast to cut their dividends this year so I’ll rule them out, however Bellway looks like an interesting opportunity with a yield of 3.8% and P/E ratio of just eight. Having said that, housebuilding is a cyclical industry and therefore I still wouldn’t classify the stock as ‘perfect’.
Lastly, a sensible option may be to wait for a market pullback. That way, as share prices decline, and dividend yields rise, more stocks will filter into my perfect dividend screen, resulting in more potential dividend investment opportunities.
