The Loonie Bin: Dividend Investing 101: What To Look For In A Dividend Stock

The Loonie Bin: Dividend Investing 101: What To Look For In A Dividend Stock

Dividend Investing 101: What To Look For In A Dividend Stock

My last post talked about dividend growth and how it plays a crucial part to any dividend investing strategy and allows you to turn a moderate return into an early retirement pay cheque. Since I've started this blog, a lot of people ask me what I look for when purchasing dividend stocks. It's not an easy process because a lot of things can happen that influence the stock market and a shiny blue chip company can lose it's luster with a cut of a dividend ( Yes, I mean you Manulife). There's so many details and facts to consider, but I've come up with a list of 6 rules to follow when you looking to buy quality, blue chip dividend stocks.

• Strong Cash Flow
• Low Dividend Payout Ratio
• A Yield of 4%
• Low debt
• Dividend Growth History
• A P/E of around 15 or lower

Strong Cash Flow

Companies are in business to do one thing, make money. If a company doesn't make as much or more then it did the year before, then it's doing something wrong. They say cash is king, and they are in fact correct. Good companies pay their dividends from their cash flow. Bad Companies pay dividends from credit. When looking up a stock to purchase, look at its current and prior years cash flow. If it's steadily decreasing each year with no increases or is consistently in the red, stay clear of it. Cash flow is the first thing I check when looking for dividend stocks. It's very important.

Low Dividend Payout Ratio

A companies dividend payout ratio tells you if the company is making enough money to maintain its current dividend. The ratio should be between 0-70% , anything higher is not healthy. If a company has a big fat dividend and low earnings per share, then they either have to make more money or God forbid, cut their dividend. The lower the ratio, the easier it is to maintain future dividend increases, which is the heart and soul of a dividend growth strategy. To find the ratio, divide the total dividend by the earnings per share (EPS).


Dividend/EPS= Dividend Payout Ratio


For example, if we look at BCE's current EPS and dividend from The Globe and Mail Investor Section , it has an EPS of 2.75 and the current dividend is $1.83.

66.5% is below the 70% level and is an easily maintained ratio. BCE is making enough profit to comfortably pay it's dividend.

A Yield of 4%

When I look at excellent companies to invest in, the yield is always one of the first things I see; not by choice but because it's always automatically calculated and thrown in the open for everyone to see. A high yield at first glance may seem like a good thing, but in actuality, it means a stock's price is decreasing. When a stock price is decreasing the amount of money a company makes on the share is also decreasing which means the dividend it is paying out cannot be maintained. The company either has to make a lot more money, or cut it's dividend. Buying a stock just because it has a high yield will start out well, but when that dividend gets cut it's like throwing a wrench in your dividend growth machine. A low yield on the other hand may have a safe dividend, but why take a risk on an investment when you can make the same return with zero risk involved by using a GIC or high interest savings account. In addition, any profit you make at a low percentage is negated by inflation.


My general rule is to never buy anything with a yield below 4%. If a company is solid, and has decades behind them with proven dividend growth, I will buy at 3.5%. You want to make at least 10% on an investment as soon as you can, and by starting at a lower percent return, it will take a lot longer to get there.

Low Debt

Debt is bad , no matter how much money you make. When a company needs to borrow money to operate, what happens when interest rates go up and sales slow down? The money they pay in dividends will most likely be used to cover the increased interest. Shazbot! When looking at a company's balance sheet, I make sure they have more then enough total assets to cover their total liabilities, otherwise I steer clear. When in doubt, always look at the cash flow, the more the better. If a company goes bankrupt, common shareholders are the last to be paid, and usually they are left hanging.

Dividend Growth History

We all love juicy yields. But if it never increases, eventually that yield of 5% will still read 5%, but the ever annoying, invisible force called inflation is a compounding fiend and will make short work of that 5% yield over time. That's why you want to invest in companies that grow their dividend every year to combat the evil inflation and your portfolio will live happily ever after. I'll use my golden boy stock as an example. Enbridge is a pipeline company that has paid a dividend for 57 years. The yearly average increase is 10%. That increase of 10% a year negates inflation, leaving some of that growth to increase the yield on your original investment. That extra growth is the heart and soul of a dividend growth machine. It will increase your portfolio a lot more then investing dividends alone. When a company increases its dividend, it shows that the board of directors are confident of the outlook of the well run company, which in turn increases the confidence of investors to buy more stock. When the stock price goes up,the value of your shares go up. It's like getting paid twice. Winner winner, chicken dinner!


So when I see a company cut it's dividend, it means that the company wasn't running at it's full potential. A dividend cut is devastating to dividend investor. Your yield decreases and the stock price plummets as everyone gets out while the getting is good. It also puts your investment back 1 to 2 years depending on how bad it is. I stay clear of a company that cut it's dividend. Manulife comes to mind and it will always be tainted to me. The only way I'll ever own Manulife, is if it increases its dividend for the next 5years. I don't care that it's been around forever and is one of Canada's most lucrative companies, cutting a dividend is a sin in my books.

A P/E Of Around 15 Or Lower

That brings me to P/E ratios. To find the price/earnings ratio, divide the price per share by the earning per share. For example, BCE's current price is $33.37. It's EPS is $2.75 as of Aug 31/2010.

So BCE has a P/E of 12.13. What does that mean? Obviously it's a ratio between earnings and share price, but it can be used to gauge the volatility and popularity of a stock. It will be argued that a P/E ratio can mean many things, and that it's an investor "assigned" value, so I won't dwell on it too much. I've read that any stock you wish to purchase should have a P/E of around 15. If it's above 15, it could be overpriced. If it's below 15, it could be undervalued and would be a good buy. Notice I said could be undervalued. It might be low for a good reason, as if the stock is losing value because of an oil spill or lawsuit. A stock with a low P/E also regarded as having low volatility, which is always good for the steady and conservative dividend investor.


A P/E ratio should never be used on it's own to pick a stock. It should be one of many calculations used to determine which dividend stock to purchase. I use it only for comparison between companies I have on my watch list.

I use these rules as a guideline, but there are many more factors to consider when choosing companies to invest in. The best way to learn is finding your own method. Everyone has different ideas on what makes good investments. Find what works for you and stick with it; or change it up if it's not working well for you.

I apologize for almost the same post as a few months ago, but I'm headed out on a rush trip to Nova Scotia for a family emergency. I planned on changing this post up a bit, but I had to rush through to update before I leave. It might be a week or more until I can update the loonie bin again. Have a good week everyone.