Many of us love to invest in dividend stocks as we can get regular income while holding onto the companies.
However, not all dividend stocks are created equal. Some companies have cut their dividends in recent times while others have grown their dividends amid economic slowdowns.
Therefore, how do we choose the correct dividend stocks to invest in? Here are three tips to keep in mind before you buy the next income stock.
Look out for stability of the business, especially the free cash flow
Firstly, a company that you are keen to invest in must have a durable competitive advantage with increasing free cash flow. This competitive advantage will protect a company’s earnings power from its competitors.
Generally, a firm’s free cash flow is used to pay dividends, reinvest into the business, make acquisitions, buy back shares, and pay off debt. A quick way to calculate free cash flow would be to deduct the capital expenditures from operating cash flow.
The higher the free cash flow generated over the years, the higher the amount of dividends that can be paid out to investors.
Companies that are unable to generate free cash flow usually do not pay dividend. Also, companies that have declining free cash flow might be forced to cut their dividend, or borrow to sustain the dividend, which is not a good sign.
Look out for a history of dividend growth
In the US, a company that has at least one dividend increase annually for a minimum of 25 years, and is part of the S&P 500 index, is termed a Dividend Aristocrat.
However, in Singapore, we do not have such a luxury. Firms such as Oversea-Chinese Banking Corp Limited (SGX: O39) and Raffles Medical Group Ltd (SGX: BSL) have paid out consistent dividends for a couple of years though. You can check out their respective Investor Relations page here and here for their dividend track record.
Others like Singapore Exchange Limited (SGX: S68) and Thai Beverage Public Company Limited (SGX: Y92) have come close to paying consistent dividends. To know more, you can visit their respective Investor Relations page here and here.
When a company can generate increasing free cash flow consistently and has a history of dividend growth, it shows that the dividends are well-protected.
Be wary of high dividend yields
The dividend yield of a company is calculated by taking the dividend per share and dividing it by the current share price. This figure alone does not tell us if a firm can go on to be a consistent dividend payer. Many buy stocks based on this metric alone, but this is akin to courting trouble.
A high dividend yield, as compared to its peers, may mean that the company is fundamentally weak and thus, has a depressed share price. On the other hand, a low dividend yield does not mean that the company is “lousy”. It may mean that the company’s share price has run up a lot due to its strong market position.
A fundamentally strong company with a dividend yield that is above the inflation rate, and one that has been paying consistent dividends, could be a starting point for our research.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. The Motley Fool Singapore has recommended shares of Raffles Medical Group Ltd and Singapore Exchange Limited. Motley Fool Singapore contributor Sudhan P owns shares of shares in Raffles Medical Group Ltd and Singapore Exchange Limited.