High Dividend Stocks
Many income investors are increasingly looking toward high dividend stocks to create extra passive income. This page will show you how to find safe dividend paying stocks, as we answer the following questions:
- Where can I find the best high dividend stocks, especially in this new era of dividend cuts and economic turmoil?
- How do experienced investors evaluate dividend stocks?
- Is there a way to protect or increase dividend income without taking on more risk?
- Does income investing preclude other types of investing, such as options?
Where to find the Best Stocks
When looking for the best stocks to buy for creating income, 3 groups come to mind:
Standard & Poor's maintains the Dividend Aristocrats, a historic grouping of companies that have increased their dividends every year for at least 25 years, which gives them a stellar record of all-important dividend growth. For more info about these elite stocks, please refer to our Dividend Aristocrats hub-page.
MLP's , Master Limited Partnerships, are companies that are obligated by law to pay out at least 90% of their earnings to "Unitholders", (shareholders), in return for not having to pay corporate income tax. There are many energy and pipeline companies within this group, which pay high dividend yields. Their distributions do not qualify for the 15% qualified dividend tax rate.
REIT's, or Real Estate Investment Trusts, are pooled funds of money, organized to invest in various types of real estate, such as shopping malls, or apartment buildings, or health care facilities. Like MLP's, REIT's also don't have to pay corporate taxes, and must pay out at least 90 % of their earnings to shareholders. There are many high dividend stocks in this group also. Their distributions do not qualify for the 15% qualified dividend tax rate.
Dividend Payouts & History
When researching dividend paying companies, always look at the following:
Dividend History: What's the company's past dividend payout history? Have they consistently maintained or increased dividend payouts? Normally, a company that can afford to consistently increase its dividends is highly valued by income investors.
Dividend Payout Ratio: This tells you how much of its earnings a company pays out in dividends. Again, this varies by industry, and also by company type, but, unless you're looking at special tax-advantaged companies such as REIT's or MLP's, you don't want to see this figure go much higher than approximately 80%. In fact, if you see that a company has a lower dividend payout ratio than its competitors, BUT it has a high dividend yield, you can infer that this company generates a lot of income.
Dividend Yields within Peer Group: Like all of the metrics we mention on this page, always compare a company's dividend yields to that of its competitors. One thing to watch for is an excessively high dividend yield within a peer group. This might be a warning signal that tells you the stock may have been severely beaten down for some reason that you'd better check out. Sometimes, such as in the crash of 2008 and early 2009, companies stock prices will spiral downward due to illogical market panic, causing their dividend yields to rise.
Dividend Yield calculation: Total Dividend paid per share, divided by current Price per share.
How to Evaluate Dividend Stocks - Looking at Balance Sheet Metrics
When evaluating dividend income stocks, it's essential to look at the company's balance sheet, to determine if it's carrying too much debt or not. Some key metrics are:
Quick Ratio: This ratio measures a company's ability to meet its short-term obligations with its most liquid assets. The higher the quick ratio, the better the position of the company. In general, look for quick ratios above 1, but this varies between industries.
The Quick Ratio calculation: (Current Assets minus Inventory) divided by Current Liabilities.
Debt/Equity Ratio: This measures how much debt a company is carrying. This figure also varies by industry, since certain capital intensive industries, such as equipment manufacturing, might require a lot more financing than, for example, a software company.
Debt/Equity calculation: Total Liabilities divided by Shareholders Equity.
Free Cash Flow (FCF): This measures how much cash a company generates after spending to maintain or increase its assets base. Some investors find this to be a more reliable metric than earnings, since cash data can't be "tinkered with" the way earnings data can.
Companies which churn out strong or increasing levels of free cash flow year after year are thought to be solid, safer companies. However, even for solid companies, this figure can vary for a good reason, if a company decides to invest in a certain project, or buy another company, that will ultimately increase its asset base.
Free Cash Flow calculation: Net Income plus Depreciation/Amortization, minus Capital Expenditures, minus Working Capital Changes = Free Cash Flow
Price/Free Cash Flow (P/FCF): This compares a company's current market valuation to its free cash flow generation. The higher this figure is, the more expensive a company is considered.
Price/Book (P/B): This figure analyzes the market valuation of a company's assets. Investors look for undervalued assets that the market may have missed. For example, land that company bought many years ago at cheap prices, but which they must carry on their books for its cost basis, instead of its current value.
Evaluating Dividend Stocks for Earnings and Revenue
Again, always compare stocks within their industry sub-group/peer group, no matter what you're measuring.
Earnings per Share: A company's net income divided by its total shares.
Price/Earnings (P/E): This ratio compares a stock's current price to its earnings per share. Often, a value investor will compare a stock's current P/E to its historic range of P/E ratios, to see where it lies in the range. Many investors put more emphasis on earnings growth figures, reasoning that a company with consistent earnings growth will see its share price grow.
Price Earnings Growth (PEG): Investors generally look for a PEG ratio below 1, which they feel shows them a stock whose price isn't overvalued, compared to its earnings growth.
Price to Sales (P/S): A way of comparing revenue between similar companies. Are you paying a much higher price/share for a company's revenue, as compared to its peers? Why? Is there a good reason, or is the stock overvalued? More importantly, is revenue growing or declining? Always look for companies with steadily increasing revenues. They may be very scarce in economic downturns, but strong well-managed companies will weather these storms.
How to Evaluate a Company's Management Performance
Here are two metrics that measure how effectively a company is managed:
Return on Assets (ROA): Important in any asset-intensive industry, such as manufacturing. This tells you how well a company used its assets to generate net income.
Return on Equity (ROE): This shows how well a company uses shareholders' money to generate profits.
How to Protect and Increase a Dividend Yield
Selling covered calls is a technique used by many income investors to increase their dividend income. This strategy is also used for lowering risk, by offsetting any possible dividend cuts, and lowering the break-even point on a stock.
A call option is a contract that corresponds to 100 shares of a specific stock. If you sell a call option, you are selling someone the option to buy your stock at a specific price, known as the strike price.
Every option has an expiration date, which is listed in its option chain. Generally, an option with a longer time period before expiration has a higher value than one with a shorter time period, due to its time value.
Quite often, a call "premium", or price, is 2-3 times the value of the underlying stock's dividends during the same time period. Hence, this additional income gives the income investor selling covered calls an additional hedge against any dividend cuts and price declines in the stock. This technique can often easily double or even triple yield income on a dividend stock.
For specific trade examples and articles illustrating this technique, just visit our covered calls hub.
Income Investing Books
Dividend & Options Investing Links
A page that gives all the terms and details of a covered call, plus a step-by-step trade example.
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