How to pick dividend stocks for your portfolio

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Dividend investing can be a good investment strategy and a near effortless way to earn passive income.

For instance, a $10,000 investment in a stock with a five per cent dividend yield will give you $500 in annual dividend income without you having to do anything.

In fact, dividend stocks are less volatile than the Standard and Poor's 500 (S&P 500) and have historically outperformed the latter.

Why? Because they provide two sources of returns: regular (i.e. steady) income from dividend payouts and stock price appreciation.

These boost your total returns and add up over time (Don't underestimate the power of compounding returns!).

Due to their lower volatility and steady income, dividend stocks tend to appeal to investors seeking lower-risk investments, particularly those who are nearing or already in retirement.

However, not all dividend stocks are created equal. They can still be risky if you pick the wrong ones. Here's how to invest in them.

How to pick good dividend stocks?

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Instead of focusing just on dividend yield, a better strategy would be to choose dividend stocks that provide steady income for the long term.

Look at the following factors to select the best dividend stocks.

1. Dividend track record

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Dividend investors who are in it for the long term would tend to prefer a company that pays out dividends regularly than one that pays a high dividend from time to time.

One way to find dependable dividend stocks is by looking at the companies that have been paying - and even increasing - their dividends for many years.

Popular Singapore and US dividend stocks include Singtel, Singapore Airlines, Keppel Corp, Apple, Microsoft, and more.

Investors eyeing a specific company's stock can delve into its dividend history on financial and investment websites, as well as stock market indexes such as Nasdaq, S&P 500, Straits Times Index and more.

2. Dividend payout ratio

The dividend payout ratio is the percentage of a company's earnings paid out as dividends.

To calculate it, simply divide the dividend per share by the earnings per share.

What the payout ratio shows us is whether a company is using too little or too much of its funds for dividends.

In general, a ratio of 50 per cent or more is considered high as that means more than half of the company's profits are paid to shareholders as dividends.

A payout ratio that is too high (>75 per cent) could mean that the dividend is unsustainable and therefore irregular, especially in times of recession. If the company runs into cash flow problems, it may reduce or suspend dividends.

That said, payout ratios vary by sector. Therefore, there is no hard and fast rule for what's considered a 'good' payout ratio.

3. Dividend growth rate

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The dividend growth rate measures how a company's dividend payouts grow over time.

Stocks with sustained and robust dividend growth can help you hedge against inflation as the increase in dividends every year helps to preserve your purchasing power.

It's important to look at a stock's dividend growth rate over several years rather than just the past year so you can get a sense of the company's growth trajectory and potential.

Consistently upward trending dividend growth rates suggest that this is a good investment, and indicates to potential shareholders that the company has a bright future.

Generally, a company whose dividends consistently grow by five per cent to 10 per cent annually is considered promising.

4. Current dividend yield

It might be tempting to pick stocks with the highest dividend yield, but a dividend yield is not the only factor to focus on.

The current dividend yield is calculated by dividing a company's annual dividend by its share price on a specific date.

For example, if the stock price is $100 and the annual dividend is $5, the dividend yield would be five per cent.

However, if for whatever reason (perhaps even due to company mismanagement) the same stock falls to, say, $50, the dividend yield then becomes 10 per cent, even though the company's stock has fallen and the annual dividend remains unchanged.

This is what's known as a dividend yield trap.

Therefore, dividend yield may be one metric to look at, but a savvy investor should also assess the company's sustainability and the growth of its dividend payouts over time.

5. Company fundamentals

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If a company's financial metrics like those above are well and good, one more thing to evaluate is its business model.

Is it fundamentally strong? Does it have a healthy cash flow, sustained profit and revenue growth? Does it have a competitive advantage over its competitors in the industry?

A company with decreasing profit and revenue would likely respond no to the above questions. And a company like that would likely have little cash left to distribute to shareholders as dividends.

The power of compounding returns

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Money makes money. That's the basic rule of compounding, and that's how compounding your returns can increase your wealth.

Therefore, investing your dividends and buying more shares of the stock instead of withdrawing them every time they're paid out to you can give you even more dividends next time. This helps to grow your returns exponentially over time.

However, reinvesting your dividends depends on whether the dividend yield is consistent.

Also consider your time horizon - if you are a long-term investor with many years left to invest, then it's a good idea to reinvest your dividends.

Otherwise, you might be better off withdrawing them for short-term needs.

ALSO READ: Rising interest rates and returns for Singapore Savings Bonds (SSB): Is it still worth investing in?

This article was first published in ValueChampion.