One of my overarching investment goals, which I imagine to be true for many investors, is establishing one or many passive income streams that enable me to live off investment returns. That’s right, I hope one day that my money is making enough money so I can sit back and relax, earning money while I vacation or sleep. And I’ve explored many options when it comes to establishing passive income streams.
Some of the most popular passive income strategies I’ve come across are real estate rental income, investing in low-cost ETFs in a taxable brokerage account, or creating side hustles, like a blog. Something that I’ve not put much of a thought into until recently is generating passive income by investing in dividend stocks.
Dividend stocks have a reputation for enabling investors to generate relatively stable passive income, even during rocky economic times. So I set out to see what the hype is all about, dig into the details on how to research dividend stocks, and see if it’s a reasonable way to diversify a portfolio.
What in the World is a Dividend Stock?
A dividend is when a company pays out money to its shareholders periodically based on exceptional company performance. The majority of stocks that pay high dividends are large companies with consistent profits.
Some of the highest performing dividend stocks that have returned and raised dividends for decades are household names like Sherwin Williams, McCormick & Co., and Lowe’s Home Improvement.
It’s up to each company if and how they want to pay out dividends to shareholders. Companies that can return huge profits pay dividends to thank their shareholders for funding them with the capital that enables them to succeed. And keeping investors happy makes them more likely to continue to support the company.
Dividends are often paid out quarterly or annually as cash or additional stock and less frequently as other property like real estate. If you don’t regularly check investments, you may overlook the dividends put into your account as reinvestments.
Popular investments like mutual funds, ETFs, and index funds all pay out dividends to investors. But the allure of individual dividend stocks is that they offer a much higher dividend than a more diversified portfolio might offer.
To see how dividends work with mutual funds, I decided to check out my Roth IRA. I discovered that Vanguard’s VTSAX mutual fund has paid quarterly dividends that I hadn’t noticed (probably because I don’t plan to use this money until much later in life).
Since I owned 354 shares of VTSAX in December at a $.378 per share distribution, my quarterly dividend was 354 * .378 = $133. And that $133 was money my money made, aka passive income! Glorious!
Researching Dividend Stock Companies
Now that you understand what dividends are and why companies pay them, it’s time to dig into how to research dividend stocks. There are several components of proper research, but trust that the time you invest in researching the best companies will literally pay dividends for you down the line. (Pun intended.)
Where to Start
I came across about a million articles online where various investing “experts” claim to know the best dividend stocks. But it’s critical to do your own research, like I did, (or seek out professional advice) before you start dumping money into any of “The Top 15 Dividend Stocks of 2021.”
I first came up with a list of companies of interest to dig into further. I then used the below components to gauge those companies’ overall health and their propensity to continue to pay dividends down the line. Let’s use one of my favorite companies, Target (TGT), as an example.
To start, I used StreetInsider.com to review historical dividends to make sure they’ve been paid consistently over the past several years. Target has paid out dividends for the last decade, so I feel good about their stability.
Be sure to take note of a company’s ex-dividend date. As long as you purchase before that date, you’ll receive the next dividend. If not, you’re stuck waiting another quarter.
Not only do you want a company that’s currently paying out significant dividends, but one that will continue to do so into the future. Earnings estimates are a way analysts set predictions for the growth or decline of a company over time in terms of their earnings per share. And companies typically try to beat those estimates to keep investors happy and see a spike in the stock price after they report earnings.
Analysts use financial models to review performance and estimate future earnings. In the case of Target, the average estimate for Q1 2021 is 2.25, meaning that analysts anticipate the earnings per share to be around or beat $2.25. A “good” earnings per share is typically viewed relative to other companies in the same industry or sector.
As the overall economy has ups and downs, so do particular sectors (healthcare, utilities, retail, technology, etc.). Before investing in any dividend stocks, it’s critical to understand the industry that stock is in and trends that may impact its future performance. Again let’s look to Target, which is part of the Retail – Discount sector. Some of its friends in that sector include Costco, Dollar Tree, and TJX Companies.
Using Zacks.com, I was able to find this chart that shows the 5-year trend for Retail – Discount Stores. While there are some dips, the overall trendline is increasing, which is where you want a sector’s performance to be if you plan to invest. Overall performance is just one metric you can use to gauge sector performance. Earnings per share, P/E ratio, and debt-to-equity are all good metrics to review across a sector to see how a company performs amongst its peers.
Since larger and more established companies tend to regularly produce high dividends, it’s a useful metric to understand before choosing a dividend stock. There are several methods to calculate a company’s valuation, one of them being the price-to-earnings (P/E) ratio. A P/E ratio shows the market value of the stock vs. the company’s earnings.
Today, Target’s P/E ratio is right around 25. This means that Target’s shares are trading at a value of 25 times their earnings. This can be calculated by taking the stock price of $192.49 and dividing it by the trailing twelve months’ earnings per share of 7.55.
If a P/E ratio gets too high, meaning the stock price is significantly higher than earnings, it potentially means that a company’s stock price is overvalued. But it’s just one of several factors to take into account, and it’s also where a broader industry understanding can come in handy to determine if a stock is performant or overvalued.
The debt-to-equity ratio gauges the amount of money financed by lenders (debt) vs. funded through shareholders (equity), and typically the lower, the better. A ratio of one indicates debt and equity are equal. In the chart below, you can see that Target generally hangs out around 1, which is an excellent spot for a business to be.
When the ratio is lower, a company uses more equity than debt to fund its assets and operations. Using equity instead of debt is a lower risk. Companies that turn to debt as the primary funding source of their operations are viewed as riskier.
Steady Cash Flow
Cash flow is the amount of money that’s actually coming in and leaving a company. You’ll want to look for companies increasing their cash and cash equivalents at the end of each 12 month period, which Target has done repeatedly over the last 5 years.
Final Thoughts on Researching Dividend Stocks
One of the biggest mistakes a new investor can make is to see a high dividend and blindly invest. The whole point of researching dividend stocks is that you take the time to understand the company and sector before you put your hard-earned money into it. Below are just a few of the things you may want to ask yourself while researching a dividend stock.
- Has the company paid out dividends for at least several years?
- Are analysts projecting positive earnings expectations for the next several quarters?
- What industry is this company in? How is the industry trending overall?
- How does the company’s price to earnings ratio look? Are they potentially overvalued? Undervalued?
- What is the debt-to-equity ratio? Is the company overleveraged with debt and potentially a more risky purchase?
- Is the company increasing cash and cash equivalents year over year?
- Do I like this company and want to support their business?
Your investment goal, like mine, is likely to make returns. But remember that by purchasing a company stock, you’re investing in the success of the business, so it’s best to know what that may look like over the next several years.
Contributor’s opinions are their own. Always do your own due diligence before investing.
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