At least initially, buying a dividend stock can seem straightforward. You find a company, check its yield, buy it and then wait to collect the payments.
That being said, seasoned investors know that there’s more to a stock than just the yield.
A stock providing a yield of 6% is attractive for getting income today. Another option that offers 2% could be appealing to an investor with years to build out that position.
Neither of those indicates whether the dividend is affordable or whether the shares offer good value.
Those are just some of the questions to consider when buying a dividend stock. Here’s a look at the main three that new investors should ask before buying.
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Question #1: Can the business afford its dividend?
In simple terms, all companies offer a product or service that they charge their customers for. The money that comes in from those products or services is, in part, where a dividend comes from.
For prospective investors, the real question is how much of that cash goes toward the dividend, and how much remains in the business.
For example, let’s look at Enbridge (TSX: ENB). Enbridge is one of the larger energy infrastructure companies on the planet. The company offers crude and natural gas pipelines as well as a natural gas utility and a portfolio of renewable energy assets.
As of the time of writing, Enbridge offers a dividend yield of 5.8%. That’s an attractive starting income, but let’s look at how Enbridge funds that dividend.
Enbridge doesn’t use a straightforward earnings-based payout ratio. Instead, it uses something called distributable cash flow to determine its dividend payout. The company targets a payout ratio of 60% to 70% of that distributable cash flow. Anything left over beyond that is available to reinvest in the business.
That target leaves room to fund the dividend and invest in growth, provided Enbridge generates that expected cash flow.
Question #2: What will support future dividend increases?
Having a long uninterrupted record of dividend increases is an encouraging sign. For investors looking at buying a dividend stock, the next question is where future increases will come from.
For this example, let’s take Fortis (TSX: FTS). Fortis is one of the larger utility stocks in North America with assets across Canada, the U.S. and the Caribbean.
As of the time of writing, Fortis offers a yield of 3.3%. The company is also targeting annual dividend growth of between 4% and 6% through the end of the decade.
Part of the reason why Fortis can reliably do that is thanks to its regulated utility business. In short, as Fortis’ existing assets are upgraded and new assets are brought online, they support future earnings growth. And the business model itself is incredibly defensive, which adds to that stability.
The end result is Fortis continues to provide investors with annual increases to that dividend. In fact, Fortis has the second-longest streak of increases in Canada, currently at 52 consecutive years.
Question #3: Does the income fit my investment goals?
To help answer that question, let’s look at Canadian National Railway (TSX: CNR). Like Fortis, Canadian National offers a highly defensive and necessary service. But the railway’s yield of 2.1% is often dismissed by investors looking solely at that yield.
That being said, investors with a long-term portfolio may view Canadian National differently. The longer timeframe provides a longer runway to invest in the stock and let those reinvested dividends compound.
Canadian National provides an essential transportation service, although freight demand is sensitive to the economy.
Before buying a dividend stock, check the whole investment
No stock, even the most defensive, is without risk. The three options mentioned above all have their own risks despite having some defensive appeal.
But together, the three investments each offer something for an investor looking at buying a dividend stock. That could be higher income in the case of Enbridge, a stable recurring payment from Fortis and long-term compounding from Canadian National.
In my opinion, one or all of the above should be core holdings in any well-diversified portfolio.
Buy them, hold them and watch your income grow.
