How to Pick a Dividend Stock
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Assess the Risk + Make Sure You Understand Business
Picking an ideal dividend paying stock is a lot harder than simply running a screen and seeing what company currently offers the highest yield. If it was that easy, there would be a lot more attention given to high yielding real estate investment trusts such as the ARMOUR Residential REIT (NYSE: ARR), which yields 18.8%. ARMOUR invests in adjustable rate, fixed rate and hybrid adjustable rate mortgage backed securities and utilizes leverage quite extensively to magnify their returns. In addition to risky operations, ARR has been showing signs of a declining revenue and earnings trend. Although the company does in fact support a strong dividend right now, risk adverse investors may want to stay away from some such high yielders.
Avoid Accidental High Yielders
So let’s assume that the dividend seeking investor is interested in a stable mid or large cap company with basic easy to understand operations. Investors who are trying to attain a certain level of income should look beyond the yield but also at the historical performance of the stock in order to avoid an accidental high yielder. Pitney Bowes (NYSE: PBI), for example, operates with a basic business model, offering various forms of business solutions, and supports a high yield of 8.5%. However, this yield of such magnitude stems from a 30% stock price drop within the last year. If Pitney Bowes maintained its current payout but had maintained at a level share price, its dividend yield would be 6% -- strong but less than 8.5%. A stock that has dropped in value resulting in an inflated high yield is something that investors should keep a look out for.
Ensure Dividend Sustainability
Dividend sustainability is another crucial process of the dividend paying stock selection process. Although dividend payments are based on cash flow rather than earnings, earnings are an important proxy for cash flow. Over the long term the two financial statement components will eventually converge; therefore, high non-cash expenses today will eventually translate to cash expenses in the future. Regal Entertainment (NYSE: RGC) is in the basic business of movie theater operations and yields a healthy 6.4% despite a relatively flat share price over the last year (small drop of 2%). The concern with Regal’s dividend is that its payout ratio is unsustainably high – over 200%. With dividend payments higher than earnings, such a system is not sustainable for the long run.
Growing Industry = Dividend Growth
Depending on the type of investor, capital gains may also be a necessary consideration in addition to the potential for income. Utilities are a great investment for purely dividend seeking investors; the industry is regulated, low in risk and the businesses are essentially a cash cow with modest capital expenditure requirements (in comparison to telecoms, which also provide solid payouts). However, the utilities would not normally appeal to young investors looking for some overall portfolio growth. Looking at Public Service Enterprise Group (NYSE: PEG), the large utility player operating in the mid-Atlantic region, the company has limited growth prospects into new regions and markets. Despite that the 4.5% dividend is stable, as signaled by the 52% payout ratio; over the last five years the dividend growth rate has only grown at an annual rate of 3.6%.
Although there are a number of solid dividend plays, in my opinion McDonald's (NYSE: MCD) is an ideal investment. Firstly it supports a low payout ratio of 48%; thus, the company is not overly strained to produce its payout. McDonald's also generates enough cash flow where it can justify growing its regular payouts. Over the last five years, the corporate dividend has grown at an average rate of 20%. Furthermore, looking at its 10-year growth chart, the stock price basically moves only in one direction: up. The business is not difficult to understand and is a strong defensive play against falling market movements. Despite yielding only 2.9%, significantly less than Armour, the blue chip corporation provides a more stable dividend and greater protection to investors while having more luster than a utility. (For more hot divided picks, see Dow’s Dividend Darlings.)
Motley Fool newsletter services recommend McDonald's. The Motley Fool has no positions in the stocks mentioned above. apinkasovitch owns shres of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.