Chasing Yield: The Balance Between Dividend Rate and Stock Stability in Canada

Dividend stocks look great with those high yields, but don’t forget to consider absolutely everything before buying.

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There is a huge problem out there for Canadian investors right now. While it can seem that finding a dividend stock with a high yield will answer all your problems, that couldn’t be further from the truth.

Unfortunately, a high dividend yield can be a sign that there is a problem with a stock. It could, in fact, be quite unstable. Let’s look into that and what you can look for when it comes to dividend safety.

What isn’t safe

When it comes to looking for a safe dividend stock, there are a few signs to look out for. The main goal that you want to achieve here is determining if a dividend looks stable and whether a company can continue to pay out those dividends for the foreseeable future.

As a company’s share price drops, the dividend yield climbs higher. And if that lasts a while, the dividend becomes less and less stable as the stock becomes less stable. What’s more, it will no longer have enough equity to cover the dividend.

To find out whether that dividend looks unsafe, it’s important to look at the company’s payout ratio. Ideally, you want a dividend stock that has a payout ratio between 50% and 80% — in that range, the company shows enough focus on the dividend to continue increases and payments. However, ensure it’s not so focused that it’s giving out far too much money to cover a dividend. This can put the dividend stock in danger of cutting its dividend.

What is safe

Besides the payout ratio, there are numerous ways to discover whether a dividend stock is safe and indeed valuable. You need to look beyond just dividend information and seek out recent earnings reports.

What investors will want to look for is growth. Is the company showing organic growth? Is it looking for opportunities through either acquisitions or new products? As long as consumers, clients, or whoever is showing interest and the company’s fundamentals are climbing, this is a good sign of dividend safety.

What’s more, look at value. Here, look at how high the company’s share price is trading compared to its earnings, known as the price-to-earnings (P/E) ratio. If it’s under the company’s historic P/E ratio, that could mark value. Furthermore, look at its enterprise value (EV) over earnings before interest, taxes, depreciation, and amortization (EBITDA). Here, you can compare the company’s value to its actual earnings after expenses. Anything below 10 is usually a sign of value.

Finally, consider debt. If a company has more debt than equity, that could be a sign that a dividend cut may come. You want a debt-to-equity (D/E) ratio under 100%. Now, let’s consider a stock that ticks these boxes.

Future favourite

For a company that investors can grab onto today, Sleep Country Canada Holdings (TSX:ZZZ) is an excellent option. Sure, its dividend yield isn’t at all-time highs, with a yield of 3.81%. However, that yield looks as snug, as it can be covered in a blanket of strong fundamentals.

Sleep Country stock currently offers shares that are up 9% in the last year. It trades at just 9.91 times earnings and a 6.19 EV/EBITDA ratio. Furthermore, its payout ratio is at just 36%, so you could see an increase in the near future if strength continues.

Finally, the company’s debts also look well managed. While a D/E ratio of 102% isn’t perfect, it isn’t problematic either. All in all, Sleep Country stock looks like a strong value stock to consider among dividend stocks on the TSX today.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Amy Legate-Wolfe has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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