Investors like to look at growing profits as an indicator of company health – and potential returns. But earnings can be manipulated. There are myriad ways to create profits on paper. Earnings are basically an accountant’s best guess of a company’s profitability. All too often, companies must restate their past reported earnings because of aggressive accounting practices, and this can cause considerable trouble for investors, who may have already based future stock price predictions on these (unreliable) historical earnings.
However, you can be sure no accountant can restate dividends. And no company can take back your dividends. Once that cash payment hits your account – it’s yours to do with as you like.
That’s why I love dividends. But, of the 400+ shares on the JSE there are only 30 – 40 right now that pay a dividend more than 7% per year. So why is 7% a year an important level?
Well, firstly it is roughly equal to the rate you will receive on a fixed deposit. Secondly, it is around 50% higher than the JSE average! But even when a share pays an outsized dividend, you still need to be cautious when investing in them – they’re not all great investments… You only want to invest in the companies that are likely to continue paying that big dividend (and hopefully grow it).
So, to help you pick the good from the bad I want to share with you my 5 rules to investing in dividend stocks – those dividend payers with the most explosive growth potential!
5 rules to follow when looking for Dividends
Rule #1 – The quality rule
Invest in high quality businesses. That means companies with long track records of stability and profitability. Preferably companies that even paid a dividend in the 2008 recession.
It’s simple really – which dividend is the better one:
Company A pays a 10% dividend for the first time in its history
Company B pays a 8% dividend this year, and hasn’t skipped a dividend for a decade.
Clearly company B’s dividend carries a bit more stability and credibility than that of Company A.
Rule #2 – The bargain rule
Invest in companies that pay you the highest dividends per rand invested. All things being equal, higher dividend yields equal better returns.
Let me explain:
Let’s say you have two companies. Both have a share price of R1.
Company A pays a 1c dividend, Company B pays a 5c dividend.
Company A will have to grow its dividend by 30% for 8 years in a row before it overtakes the dividend of Company B that increases only by inflation!
This doesn’t mean all companies with the largest dividends are the best options. They still need to prove they can sustain (and grow) that dividend. But that’s why we use the other rules to weed out the undesirable shares…
Rule #3 – The safety rule
Whilst we want big dividends, we also want growing dividends. And if a business is paying out all its income as dividends, there’s no way to grow.
So, I look for companies with a conservative dividend payout ratio. That also leaves the company with enough cash on hand to survive when times are tough.
It is calculated by taking the dividend and dividing it by earnings per share as demonstrated below:
Dividend Payout Ratio= Dividend per share (DPS)/ earnings per share (EPS)
A dividend payout ratio above 100% means the company is paying more in dividends than the profit it makes. This is usually a bad idea – as it means the company reinvests no money to maintain and grow its business.
A dividend payout ratio smaller than 100% indicates that the company keeps some of its profit on hand for expansion purposes.
Rule #4 – The no or low debt rule
It doesn’t make sense when a company pays dividends whilst it has a lot of debt.
All its doing then is effectively paying you a dividend with debt.
So, I look for dividend payers with very low, or no debt.
Rule #5 – The hedge your bets rule
You can’t be right all the time. So, you need to spread your investments over multiple stocks to reduce the impact of being wrong on any one stock.
And always remember – whilst dividends are a massively important factor in investments, they aren’t the only important one.
There are a number of fundamentals behind every stock that make it the right or wrong choice for you, many of which have nothing to do with the dividend payout.
An attractive yield will certainly draw the eye, but never invest on yield alone. To ensure you are making sound investments, always look under the hood of a potential stock and ensure you understand how that company operates and its position for the future.
If you’re not sure where to look for the best dividend investments, then make sure you read this MoneyMorning article: A simple way to grow your income through dividends.
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