Dividend stocks are hugely popular among investors thanks to their attractive combination of growth and income. However, not all dividend stocks are good investments. Here are a few top tips on how to choose the right stocks for dividend income.
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What are dividend stocks?
Basically, when a company makes a profit from its business, it can use the money in a variety of ways. One of these ways is to pay out to shareholders. This portion of a company’s profits that is paid out to shareholders is known as a dividend.
Dividend investing entails investing in stocks that pay dividends consistently.
The exact amount you get as a dividend is proportional to the number of shares you hold in the company. These are usually expressed in terms of pence per share.
How do I pick the right dividend stocks for my portfolio?
Here are five tips from Dan Lane, senior analyst at Freetrade, that investors should keep in mind when it comes to picking dividends for generating income from the stock market.
1. Look for high (not the highest yield)
Dividend yield is basically a stock’s annual dividend payment to shareholders expressed as a percentage of the stock’s current price.
Lane believes that the highest dividend yields are not always the best. High yields (above around 7%) can indicate problems elsewhere.
For example, if the price of a company’s stock falls while the dividend remains constant, the dividend yield rises. But while a high dividend yield can be an exciting prospect, it may also indicate that the company is more concerned with shareholders than with funding its operations and growth.
Lane recommends hunting for dividends with a yield in the 4% to 7% range.
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2. The best dividend stocks are ones that pay out
According to Lane, a company’s ability to pay a dividend matters more than the dividend itself.
He recommends looking at the financial metric known as dividend cover, which essentially measures the number of times a company can pay dividends to its shareholders. Dividend cover will, for example, be expressed as holding two or three times the level needed to meet the next dividend.
Cash levels on the balance sheet can also help determine whether a company can continue to pay dividends rather than offering a large dividend payout while the business is collapsing.
3. Join the dividend heroes and aristocrats
Investors should be on the lookout for companies with a strong dividend history because it demonstrates the company’s commitment to paying out dividends.
A good place to start is with the dividend aristocrats, which are companies that have consistently paid out or increased their dividends over time (10 years for UK companies and 25 years for US companies).
Another option is dividend heroes. These are trusts that have consistently increased dividends for at least 20 years and that pride themselves on keeping that record intact.
Trusts are particularly appealing because of their ability to reserve up to 15% of their income during good periods so that payments can be topped up and kept relatively constant during bad periods. Lane believes this is a huge benefit for those who require a steady income, such as retirees.
4. Diversify
According to Lane, spreading your income sources across sectors, countries, and different sizes of firms all help to reduce the impact specific events can have on your dividend income.
Investment trusts and ETFs are a good starting point to give you instant diversification.
However, even if you are holding a lot of dividend funds, check out what they actually contain. You may have a couple of funds in your portfolio and believe you are well diversified when, in fact, you are holding a few similar funds with the same combination of companies.
5. Plan your payments accordingly
If you intend to generate a regular income stream from dividends, make sure your portfolio is aware of your goal. Remember that dividend stocks have different payout periods. Different companies pay monthly, quarterly, biannually or annually.
If you want to keep a steady stream of income, you should do some research to help you build a portfolio that will pay you throughout the year.
Final word
If you are thinking of investing in good dividend-paying stocks, make sure you use a solid and reputable broker whose values align with your investing goals and strategies.
To help you narrow down your options, we’ve compiled a list of some of the top providers of online sharing dealing accounts in the UK.
