Investing in dividend stocks can be quite tricky, as you need to identify companies with capabilities to generate cash flows across market cycles. Dividend payouts are not guaranteed, which means they can be cut or suspended at any time, especially if market conditions deteriorate.
Instead of just chasing a high yield, investors should look at a company’s dividend-payout ratio, its dividend-growth history, and potential earnings growth. Ideally, a dividend-paying company should have a sustainable payout ratio, providing it with the flexibility to reinvest in growth projects, reduce balance sheet debt, and increase these payments.
Moreover, the best dividend stocks are those that have increased their payments over time, resulting in a higher effective yield. So, you need to identify companies that are part of expanding markets that allow them to grow their dividends and earnings consistently and fuel dividend growth.
Avoid investing in companies with high debt
Algonquin Power & Utilities (TSX: AQN) was among the hottest dividend stocks on the TSX in the past decade. Part of a recession-resistant sector, a majority of AQN’s cash flows were regulated. However, when interest rates spiked in the last 20 months, the TSX company was forced to reduce its dividends by more than 50%.
A dividend cut generally results in a steep pullback in share prices, as investors are wary of the company’s deteriorating financials. Currently, AQN stock trades 65% below all-time highs and offers you a dividend yield of almost 7.6%.
Utility companies are capital-intensive and require vast amounts of debt to fuel their expansion plans, which is a double-edged sword if interest rates rise at an accelerated pace.
The payout ratio should be sustainable
Typically, a low payout ratio provides a company with the flexibility to maintain dividends even if cash flows or earnings decline for a couple of quarters. Technology and banking companies are asset-light and have a payout ratio of less than 50%. Alternatively, debt-heavy companies part of sectors such as real estate, energy, industrials, and utilities may have a much higher payout ratio.
One such clean energy TSX stock is Innergex Renewable (TSX: INE), which ended the second quarter (Q2) with $6 billion in debt. Its free cash flows in Q2 were $115.3 million, much lower than the $173.64 it earned in the year-ago period. It meant INE’s payout ratio surged from 82% to 127% in the last 12 months.
Down 50% from 52-week highs, INE stock currently offers you a tasty dividend yield of 7.3%. Does the ongoing pullback indicate investors are bracing for a dividend cut?
Invest in blue-chip stocks such as Enbridge
Among the most popular TSX dividend stocks, Enbridge (TSX: ENB) currently offers you a yield of 7.7%. A diversified energy infrastructure company, Enbridge has increased its dividends by 10% annually in the last 28 years, which is exceptional for a company part of the cyclical energy sector.
With a payout ratio of less than 70%, Enbridge aims to increase its cash flows between 3% and 5% annually in the next two years, which should support further dividend hikes. Enbridge’s cash flows are tied to long-term contracts and indexed to inflation, making them resilient across business cycles. Priced at 17 times forward earnings, ENB stock also trades at a discount of 20% to consensus price target estimates.
