5 Metrics to Check Before Buying a Dividend Stock
By: Jonathan Wolfgram,
Five metrics to check before buying a dividend stock offer investors seeking reliable passive income a screening process.
The five metrics to check before buying a dividend stock, especially any high dividend stocks with a consistent payout, will help empower investors to make wise, profitable decisions. Virtually every week, DividendInvestor.com provides new recommendations for the best dividend stocks to add to your portfolio, but it helps to use online tools to invest wisely.
The first half of that equation comes in screening for dividend stocks — both the Dividend Screener on DividendInvestor.com and the platform designed by our partners at Stock Rover are excellent tools for investors to gather the data they need. Interpreting that data, however, is a challenge in itself.
That’s why, starting with the basics, we compiled a list of the five metrics to check before buying a dividend stock. This article will tell you what these metrics are, where they come from and what they mean for practical, profitable investing.
5 Metrics to Check Before Buying A Dividend Stock: Dividends Per Share
Dividends per share is the first and most fundamental of the dividend metrics. When a company decides to reward its shareholders by distributing a dividend, it sets aside a specific amount of a company’s money for every outstanding share, or dividends per share. For every share of the company you own, you’ll receive a payout equal to the dividends per share multiplied by however many shares are in your portfolio.
Take the dividends per share of 3M (NYSE:MMM) as an example:
While there are dividends that payout annually or monthly, the vast majority of dividend payers distribute on a quarterly basis. In 2020, 3M paid a dividend per share of $1.47 every quarter, meaning for every share of MMM you owned, you would have received $5.88 by year’s end.
For example, let’s say you owned 100 shares of MMM. In 2020 alone, the company would have paid you $588.00 in dividend distributions.
5 Metrics to Check Before Buying A Dividend Stock: Dividend Yield
A $588.00 check just for owning some stock sounds nice until you realize that 100 shares of 3M, at their current price, cost $18,466.00. That’s where dividend yield comes in, which effectively measures the efficiency of your investment — dividend yield tells you how much you can expect to be paid relative to the amount of money you invest.
To find the dividend yield, we use the following formula:
Let’s use 3M as an example again.
Looking back to the data table above, we see that 3M pays a dividend of $1.48 per share per quarter, equivalent to an annual dividend of $5.92 per share. We divide that number by the current share price, $184.19 (as of March 11, 2021), and get:
So 3M has a forward dividend yield of 3.2%, meaning for every $100 you invest in the company, you’ll receive a dividend distribution of $3.20.
However, many investors stop there, thinking that in order to make the best investments, they need only find the stocks with the highest dividend yields!
Not so fast.
A closer look at the formula shows us that two things will make the dividend yield larger: high dividend distributions — which are good — but also falling share prices. Many high-yielding companies are those that may have paid a fair dividend in the last year but since then have seen their stock price plummet. If a share price changes suddenly, it may take several months for the financial defeat to be reflected in historical dividends. A company may have paid a nice dividend three months ago, but if it went belly-up since then, the dividend yield will appear unnaturally high.
Dividend yield is an important metric, but it’s for this reason that it cannot stand alone. To evaluate the actual performance of a company as a dividend payer, we need to look past high yields and evaluate a company’s fundamentals.
5 Metrics to Check Before Buying A Dividend Stock: Dividend Growth Rate
For long-term investors, a stock’s dividend growth rate is arguably more important than its yield. A high yield will reward investors in the short-term, but if it drops gradually over time, investors may be sorely disappointed in their waning returns. Even if the dividend distribution stays constant, inflation will gradually eat away at investors’ profits as the equity becomes less viable over time.
That’s why it’s important for dividend-paying companies to be growing their dividend distributions, both to keep ahead of inflation and to reward their long-term investors. Dividend increases may be seen every period or perhaps just on an annual basis, but we track the average growth rate over a multi-year period.
In the case of 3M, we see that the company consistently increases its dividend, although its growth rate has slowed over the last 10 years. However, since the company has increased its dividend every year for a considerable period of time, we view it as a stable investment unlikely to decrease its dividend in the foreseeable future.
5 Metrics to Check Before Buying A Dividend Stock: Consecutive Dividend Increases
Investors with a strong focus on long-term reliability of income may look to consecutive dividend increases to evaluate their stock picks. Consecutive dividend increases as a metric is exactly that — how many years in a row the company has increased its dividend distribution. Dropping a dividend or even keeping it level for a year resets a company’s streak to zero.
Our example stock, MMM, has increased its dividend distribution 62 years in a row. This makes it a member of the Dividend Aristocrats — an elite group of S&P 500 companies that have increased their dividend payouts 25 or more years in a row. 3M is also a member of an even more exclusive group of companies called the Dividend Kings, a title reserved for companies with consecutive dividend increases of 50 or more.
Dividend Aristocrats and Kings, as well as other equities with uber-high consecutive dividend increases, are stable investments. A long streak of increasing dividend distributions not only shows a company’s ability to weather financial challenges and the ups and downs of the market but demonstrates a continued optimism for the future of the company.
That said, there are plenty of strong dividend investments without long consecutive dividend increase streaks, but the Dividend Aristocrats and Dividend Kings serve as excellent starting points for investors hoping to stabilize their portfolios.
5 Metrics to Check Before Buying A Dividend Stock: Dividend Payout Ratio
Dividend growth and consecutive dividend increases offer historical data points for analysts and investors to estimate the likelihood of a company cutting its dividend, but the dividend payout ratio serves a similar purpose on a more current basis.
The dividend payout ratio informs investors how much of a company’s profits are distributed as dividends, or rather, how what percentage of overall profit is being given back to shareholders. It is calculated using the following formula:
Lower dividend payout ratios are considered safer since the company will be able to continue its dividend payments should it be met with financial difficulties. Additionally, it often means the company is reinvesting a substantial share of its profits back into its own growth. This does, however, mean less money in the shareholders’ pockets.
A payout ratio between 35 and 55% is generally considered good — enough that shareholders are making a meaningful profit, but not so much that the company may become unable to pay its dividend in the near future. Payout ratios much higher may indicate that a company may be headed towards a dividend cut to bring its distributions back into a sustainable range.
An exception to this rule is real estate investment trusts (REIT). For information on how to evaluate a REIT’s payout ratio, read our article on the topic here.
3M has a dividend payout ratio of 63%, meaning for every dollar the company makes, $0.63 of it is being distributed back to shareholders. This is only slightly above what is considered the sustainable range, but since the company also maintains high dividend growth and a long streak of consecutive dividend increases, we can assume the dividend is safe despite this.
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Jonathan Wolfgram is an editorial staffer who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes for www.DividendInvestor.com and www.StockInvestor.com.