There’s an allure to dividend stocks that often leads many to mistakenly label them as “safe.” However, let’s be clear: dividend stocks are still equities, and with that comes inherent risk.
Moreover, not all dividend stocks are created equal, and the nuances between them can significantly impact your portfolio’s performance.
For many budding investors, the immediate reaction is to jump at stocks boasting high yields. At a glance, it may seem like the obvious choice — who wouldn’t want a higher return on their investment?
But this approach can be misleading and potentially hazardous to your financial health. Welcome to the world of “yield traps,” where a high yield might mask underlying issues that lead to future losses.
Today, I’ll unpack two vital indicators every dividend investor should have on their radar: the payout ratio and the dividend growth rate. Understanding these metrics will provide a clearer picture of dividend safety and sustainability.
The payout ratio
The payout ratio is a simple, yet powerful tool. It tells us the percentage of a company’s earnings that are paid out to shareholders as dividends. It gives us a snapshot of a company’s ability to sustain its current dividend payment.
Formula: Payout Ratio = (Dividends per Share / Earnings per Share) x 100%
A high payout ratio could indicate that a company is returning more money to shareholders than it’s earning, which might not be sustainable in the long run. Conversely, a lower payout ratio suggests that a company retains a good portion of its earnings, offering a cushion if earnings drop in the future.
Here’s a quick rule of thumb on how to interpret this metric:
- 0%–50%: Generally viewed as safe. The company retains a substantial amount of its earnings, suggesting room for future dividend growth and a safety net for potential downturns.
- 50%–80%: Moderate. The company is paying out a more substantial chunk of its earnings as dividends. While not necessarily alarming, investors should monitor other financial metrics to ensure ongoing sustainability.
- Over 80%: Warning territory. A high payout ratio may indicate limited room for growth or potential dividend cuts, especially if earnings face any decline.
The dividend growth rate
The dividend growth rate is a metric that demonstrates how much a company’s dividend has grown over a specified period, usually three or five years. In essence, it showcases the annualized percentage growth of the dividend payment.
This metric is all about the future potential and reliability of that income stream. A consistently growing dividend can be an indicator of a company’s robust financial health, profitability, and commitment to returning value to shareholders.
Moreover, regular dividend growth can help your income stream keep pace with or even outstrip inflation, preserving your purchasing power.
Finally, many investors also consider how many consecutive years a company has sustained or grown its dividend payment. The length of this streak can be telling. Generally speaking, the longer a company has maintained or grown its dividend, the more reliable that dividend appears.
An ETF that checks for both
Investors can easily check prospective dividend stocks for both of these metrics via various online stock screening services, but personally, I prefer to outsource the work to an exchange-traded fund (ETF).
My pick here is BMO Canadian Dividend ETF (TSX:ZDV). This ETF uses a rules-based methodology to select Canadian dividend stocks that have better three year dividend growth rates, yields, and payout ratios.
Currently, ZDV is paying an annualized distribution yield of 4.62% net of its management expense ratio of 0.39%. Even better, the dividends from this ETF are paid on a monthly basis, unlike most dividend stocks that pay quarterly.
