Investing for dividends is extremely satisfying. What’s better than regularly receiving monthly or quarterly cash payments for simply being a shareholder of a stock?
Some investors focus their entire investment strategy on maximizing dividend income. While this is a very attractive investment strategy, new investors need to be cautious.
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There are pitfalls to dividend investing
Dividend investing is not as easy as finding dividend stocks with the highest yield and then collecting the massive payout. In fact, that is a major trap that new investors fall into.
High dividend yields (those 7% or higher) can seem attractive for elevated immediate cash returns. Yet, they can also be extremely risky investments. There is generally a good reason why a stock has an elevated yield.
These reasons can be increasing competition, declining sales, poor management decisions, a weak balance sheet, or an unsustainable dividend payout. The market sees the risks, drops the stock, and increases the dividend premium to compensate for the risk.
The payout ratio is a great measurement of income sustainability
That brings up the payout ratio. This is a fundamental investing ratio for dividend investors. The payout ratio divides the annual dividend by a company’s annual earnings or cash flows. Basically, it is a test for whether the dividend is sustained by the cash flows generated in the business.
Ideally, the lower the payout ratio, the better. A company with a modest dividend payout ratio can pay its dividend while still internally funding growth in the business. Also, a company with a lower payout ratio has more flexibility to increase its dividend.
TELUS: A cautionary tale
TELUS Corp. (TSX: T) is a perfect example of why the payout ratio is an important metric to monitor. TELUS has faced several headwinds over the past few years, including increased competition, rising capital expenditures, and a ballooning balance sheet. It promised investors a surge in cash flows that just never arrived.
TELUS’ dividend yield rose as high as 12.5% in July this year. Its stock declined by negative-30%. Its dividend payout was 179% over adjusted earnings. That was just before TELUS cut its dividend by 55%.
Unfortunately, the TELUS board was too little, too late with the dividend cut. The market still has serious concerns around its debt burden and ability to sustain earnings. Its stock has collapsed -20% since its dividend cut. It yields 7% even after the cut. With the weak price momentum, it is still not one I would be venturing to touch.
Pembina: A solid bet for dividend income
If I were looking for a stock with an attractive (but also sustainable) yield, I would look at Pembina Pipeline (TSX: PPL). It has a 4.3% yield today.
Unlike TELUS, Pembina’s business is firing on all cylinders. Canada is investing in its energy production capacity, and Pembina is at the heart of this theme. It has pipelines, midstream assets, storage, and export terminals – everything a producer needs to get production to market.
It also has a substantial backlog of growth projects including LNG terminals, data centre power plants, and processing capacity. With a strong balance sheet, it has been able to grow with modest leverage and internally generated cash flows.
Pembina’s payout ratio to earnings sits around 89%. To cash flows, that ratio sits closer to 63%. The company has been able to both grow the business and increase its dividend annually since 2022. For a relatively low risk business with a nice mix of growth and income, Pembina is an ideal dividend stock for new investors.
