One of the reasons to invest is to achieve financial independence. The idea is that eventually your portfolio will effectively work for you, giving you a salary when selling stocks, or in dividends from dividend stocks.
I would consider dividend stocks to play an important role. These can perform well without the level of risk we see in companies that opt out of paying dividends in order to accelerate.
When buying dividend stocks, I consider these three variables.
1) Dividend yield
The dividend yield is the percentage of the investment made received back as cash annually. Companies who pay dividends will return between 2-5% to shareholders on average.
An important factor to consider is how the yield looks alongside the share price. If an investor receives an 8% dividend, but the stock goes down 20%, then obviously this is a bad investment.
I look for companies that have been performing well, and growing dividends at the same time. This is a sign of confidence that the future is bright.
BAE Systems’ dividend has been growing since inception in 1999. Currently paying out 3%, it has a healthy work pipeline in the geopolitical environment. Plus a diverse portfolio as Europe’s largest defence contractor.
Investing platform IG Group Holdings pays a 5.5% dividend, growing at 8% annually since 2012.
However, the earnings growth of both are below average, so although the dividend is growing, the share performance may not be as attractive.
These Dividend Aristocrats, with increasing dividends over the last decade, demonstrates a management team building a company with reliable, and predictable growth.
2) Dividend cover
Think of dividend cover as the ability the company has to pay more in future dividends. Returning to BAE Systems, a payout ratio of 56% demonstrates ample room for future growth.
Utility provider United Utilities has a payout ratio of 4%, showing scope for increasing its 4.4% yield further. The stock performance has been below the average of the sector, though. So investors need to weigh up the dividend as well as the shares themselves.
3) Return on equity
When receiving a dividend from a company, we want this as a reward for owning a great company, rather than an incentive for owning a failing one.
To ensure that the company execute well, I analyse the ROE (return on equity).
If a company is using money well, then it can be a lucrative investment. But when receiving a dividend from a company drowning in debt, and struggling to make profits, it feels less of a reward.
Rio Tinto has seen some tremendous growth in the last month, as China loosens policy, and signalled returns to spending in steel production.
At a ROE of 14.46%, compared to the materials sector average of 4.5%, we see that the company is highly efficient in its operation. This is a great indicator for future performance, and investor confidence.
Overall
There’s definitely a place in my portfolio for dividend stocks. If investors pay attention to variables such as the ROE, dividend yield, and dividend cover, then they can offer a regular income and great growth potential.
