How To Build A Dividend Stock Portfolio
Dividend stocks are a great way for investors to generate income from their investment portfolios. I have written a number of posts on the importance of dividend investing and how it can work for you. You can use dividends to help your portfolio boost its investment returns. The following is a guest post by Mike from The Dividend Guy Blog and a dividend investing beginner website: What is Dividend.
Creating A Dividend Stock Portfolio
Would you like to receive money from companies on a monthly basis?
If so, then dividend investing may be for you!
Over the past 40 years, 58% of the stock market’s yield was produced by dividends. Dividend stocks maintain a much more stable value over time (meaning less stress for investors) while producing a constant cash flow that is much better at beating the rate of inflation.
If making money is not a strong enough reason for you to consider dividend investing, then I add another one: it’s passive income!
Passive income has been quite a buzz word, and has even been promoted by several personal finance “gurus.” Passive income means making money while doing nothing. This is exactly what dividend investing is about: once you have worked very hard to build your portfolio, money will be generated automatically.
But in order to build a solid dividend stock portfolio, you must follow some key dividend ratios. I’ve pulled the only 5 Dividend Ratios you need to follow to build your portfolio:
Dividend Yield Ratio
This is a simple dividend ratio to understand but still very important. The dividend yield is the percentage of return that you will earn from the stock that you purchase. Therefore, if you invest $1,000 in a stock that has a dividend yield of 3%, you will earn $30 in dividends for the year.
How to calculate the dividend yield ratio
You can usually obtain this information from investing websites like Yahoo Finance. However, you can also calculate it. Here’s an example:
Company name: Johnson & Johnson
Company ticker: JNJ
Stock price: $65.94
Annual dividend payout: $2.28
Dividend yield (annual dividend payout/stock price) = ($2.28/$65.94) = 3.46%
Quick guideline on Dividend yield: must be over 3%. Personally, I like when I buy a dividend stock giving me something in return. Low dividend stocks (under 3%) don’t count as “dividend stocks” under my own definition.
Dividend 1 Year Growth Ratio
The dividend 1 year growth ratio will tell you if the company has recently increased or cut its dividend. This is interesting information as it provides you with an idea of the management team’s perception of the future of the company. If the dividend 1 year growth ratio is positive (let’s say 5%), this means that the company likely believes it will be able to maintain its dividend payout in the future. Conversely, a dividend 1 year growth negative would reflect a dividend cut, which leads to potential financial problems over the short term (for example. BP cut its dividend back in 2010 when their pipeline broke and created one of the most devastating oil leaks in history).
How to calculate the dividend 1 year growth ratio
You can usually calculate the 1 year growth ratio by taking the prior year’s dividend payout and the present year’s dividend payout. For example, if a company paid a $1 dividend per share last year and is now paying a $1.10 dividend per share, your 1 year dividend growth is 10%.
Quick guideline on dividend 1 year growth ratio: It must be positive (5% and up is better, but do note that in some years a company may not have any dividend increases.
Dividend 5 Year Growth Ratio
This is exactly the same idea as the dividend 1 year growth ratio. What is interesting with the 5 year dividend growth ratio is that you can see a clear trend in the dividend payout. Since dividend investing is based on a long-term horizon strategy, you must look for companies that are continuously increasing the dividends paid out. If the 5 year growth is similar to the 1 year growth, this means that the company has the habit of systematically increasing its dividend, year after year.
You can find the best dividend payers (companies that have been increasing the dividend for more than 5 years) from the following list:
Dividend Aristocrats list
Dividend Champions list
Dividend Achievers list
Quick guideline on dividend 5 years growth ratio: must be over 5% (then you know that you have a consistent increase in your dividend payout).
Dividend Payout Ratio
The dividend payout ratio (DPR) is very important as it gives you a clear indication of whether or not the company will be able to maintain its current dividend.
How to calculate the Dividend Payout Ratio
Here’s the ratio formula:
DPR = Dividends Per Share / Earning Per Share
For example, if a company paid out $1 per share in annual dividends and had $3 in EPS, the dividend payout rate would be 33% ($1 / $3 = 33%). Another way to get the same ratio is to calculate:
Dividends / Net income
In the end, what is important is to understand if a 33% dividend payout rate is high or low. I personally prefer a dividend payout ratio under 75% (and aiming usually for 50% or lower). This means that the company has a lot of room to maintain its dividend in the future.
Quick guideline on dividend payout ratio: must be below 75%.
Earnings Growth Ratio
The logic behind looking at earning growth is to know (again) if the company will be able to maintain its dividend. Earnings are defined as revenues minus costs, minus taxes. In other words, earnings are what is left in cash in the company (e.g. what is left to be distributed as a dividend or reinvested). Investors can look at earnings growth to see if a company will be able to afford a dividend increase in the future.
Quick guideline on earning growth: must be positive. If the stock you look at shows a negative earnings growth, chances are that its dividend payout will be affected over time.