In this short video, learn how to identify reliable dividend stocks, and get two TSX dividend stock ideas that we think are good buys today.
Prefer to read? There’s a transcript below.
Transcript
Nick Sciple: I’m Motley Fool Canada senior analyst Nick Sciple, and this is the Five-Minute Major, here to make you a smarter investor in about five minutes. Today we’re discussing our favorite Canadian dividend stocks. My guest today is Motley Fool Canada Chief Investment Officer, Iain Butler. Iain, thanks for joining me.
Iain Butler: Great to be here, Nick. It’s been a couple of weeks since one of these, so it’s good to be back.
How to identify a good dividend stock
Nick: Excited to be here as well, Iain. Before we get into our dividend stock picks, what are the things investors should be looking for when they go looking for dividend stocks?
Iain: Well, this is going to sound a little ridiculous, and I wrote down some notes, and it sounds totally ridiculous. But what I look for is that the company that’s paying the dividend has the financial wherewithal to actually pay the dividend. Imagine that! So I mean, it sounds obvious. But where I found a lot of investors getting tripped up is that they focus on the wrong metrics to evaluate this capability.
What is a payout ratio?
So the most popular ratio is known as the payout ratio. You’ll see this figure on any number of websites as you travel the Internet.
Generally speaking, the lower the ratio, the more able a company is to afford its dividends. So said differently, a 50% payout ratio is more attractive than a 100% payout ratio. 100% means they’re paying out all of their — well, we’re going to get to how they’re paying out.
Why payout ratios can be misleading
So my problem with the payout ratio is that the calculation uses the dividend payout as the numerator, which is fine.
But the denominator is net income. And the problem with net income is that it has very little to do with a company’s ability to pay its dividend. All kinds of accounting trickery comes to mind. But that’s not necessarily the right word. Accounting “adjustments” come into net income, and the fact is, dividends are actually paid out of a company’s free cash flow. So the right way to calculate the payout ratio is to have dividend in the numerator and free cash flow in the denominator, and we could spend the full five minutes just on this metric. But I wanted to make that clear. And now we can jump into, Nick, your favourite Canadian dividend stock right now.
Canadian Natural Resources
Nick: My favourite Canadian dividend stock right now is Canadian Natural Resources (TSX:CNQ). For folks who aren’t familiar, Canadian Natural Resources is the largest oil producer in Canada, with among the longest-lived and lowest breakeven energy resources in the world, which provide the company with consistent and reliable cash flows — to your point on payout ratio. Canadian Natural Resources pays out about 50% of its free cash flow via dividends, which allows the company to support that dividend payout while also investing in the business for growth. Its current yield is 5.4%. That’s substantially higher than its Canadian oil and gas peers, and also more global oil and gas peers. Think about your Exxons (NYSE:XOM) and your Chevrons (NYSE:CVX). Moreover, this is a company that has regularly increased its dividend every year for the past 25 years, and if you look back over the past five years, the dividend has increased 176% during that time period. So with Canadian Natural Resources, you have a leading company in its industry with a very well covered dividend, offering an above average yield today with a consistent track record of increasing those dividends over time. That’s exactly what I look for in a dividend stock. Iain, what about you? What is one Canadian dividend stock on your radar right now? And why?
CN Rail
Iain: It’s fantastic, and I’ll certainly echo CNQ’s qualities that you mentioned. Well done. So, mine is similarly not a fancy company or not a real stretch to believe — and narrowing down to one is tough — but CN Rail (TSX:CNR) is a recent re-recommendation in Stock Advisor Canada, and that’s certainly a company that fits the bill when it comes to its ability to afford its dividend. CN’s current yield is about 2.5%.
And while you can certainly do better than that on a number of other fronts (there’s plenty of companies out there that offer a bigger yield than 2.5%.) But CN Rail has been one of the more reliable dividend growers in the Canadian market, similar to CNQ, over the past 25 years. So I think just taking a step back for both of these companies, Canadian Natural Resources and CN Rail, when one is considering a dividend strategy, whether it be for an entire portfolio or just a corner of one’s portfolio, it’s been my experience that you’re better off sticking with these tried and true dividend performers. You can get tempted by the 11%, 12%, 13% dividend yields that are out there.
But the stock market’s pretty darn good at sniffing out dividend duds, and when the higher yields tend to indicate a company is a dividend dud, you can do far better when you find these reliable growers, even though their dividend yields may not look as attractive on paper over over time. That dividend growth really provides a relatively low-risk, significant return.
Nick: That’s right. You’ve got to combine that dividend yield with how sustainable that dividend can be over time. Often those current yields in the double digit ranges indicate that a future yield might be in the 0% range, or certainly substantially lower than what it’s showing you on the paper today. Well, we’ve given you a couple great Canadian dividend stocks to have on your radar as you consider additions to your portfolio. That’s all the time we have for this edition of the Five-Minute Major. Thanks so much for joining us, and we’ll see you next time.
