Many investors, including me, dream of being able to generate a steady source of passive income. By growing that passive income over time, investors will be able to comfortably supplement or even replace the income they receive from their jobs. This gives you a bit more freedom in being able to focus your time on things you’re very passionate about.
One way to build that source of passive income is by investing in dividend stocks. Although these stocks are generally easier to filter out than growth stocks, in my opinion, the process can still give investors a tough time. In this article, I’ll discuss three things that investors should look for when looking at dividend stocks.
Look for a long history of paying dividends
The first thing that investors should look for is whether a company has a long history of paying dividends. If a company doesn’t have that rich history, then it should be regarded as a riskier dividend stock. An example of companies that satisfy this requirement are the Canadian banks. The Canadian banking industry features many outstanding dividend stocks. Certain companies like Bank of Nova Scotia have been paying shareholders a portion of their earnings for nearly two centuries.
It should be noted that a company’s ability to pay dividends over a long time isn’t the only way that investors should consider historical performance. Investors should also look at whether a company has a long history of increasing dividend distributions. Canadian companies that are able to increase dividends for at least five consecutive years are known as Canadian Dividend Aristocrats. Fortis and other utility companies should be considered here.
Choose stocks that can increase dividends at a fast rate
Keeping with the theme of increasing dividends over time, investors should look at how fast a company’s dividend grows over the years. Generally, I look for a five-year dividend-growth rate of at least 5%. Over the long term, that growth rate is more than double the average inflation rate. Some of the best dividend companies can maintain dividend-growth rates of more than 10%. Take goeasy for example, since 2014, its dividend has grown at a CAGR of nearly 35%.
Canadian National is another company with an outstanding track record, when it comes to growing its dividend. This Dividend Aristocrat has managed to maintain a five-year dividend-growth rate of over 12%.
Make sure the company’s payout ratio is relatively low
Finally, investors should make sure that a company’s payout ratio is fairly low. This is simply a calculation that takes into account a company’s earnings and its dividend distribution. Generally, companies with a lower payout ratio should be seen as a safer dividend. This is because the company has more flexibility when it comes to being able to pay its dividend if revenues were to take a hit in one year. Again, Canadian National Railway is an excellent example of a company that satisfies this characteristic (37.7%).
