Only earning money from stock appreciation can be stressful sometimes. Unrealized gains can suddenly disappear during a market correction. Dividend stocks can provide some stability on a stock portfolio.
Checking for the P/E ratio, payout ratio, and the balance sheet of a dividend stock may be the best way to determine if the dividend is sustainable or not. Also, a dividend stock ETF may be the best way to diversify dividend stocks.
This article will start discussing the basics of dividend stocks, until how to actually buy a dividend stock on an investing platform. Here are 4 steps to get started.
1. Understand the Risks and Upsides of Dividend Stocks
Advantages
- Consistent Income
Having consistent income on a portfolio is an appealing advantage of having dividend stocks. After all, stocks typically go up and down pretty often. Receiving dividends give a sense of earning constant money from stocks.
Dividend stocks can help motivate to continue investing. Receiving dividends, even only a few bucks, can give some satisfaction from earning something.
Also, holding a dividend stock on a stock market downturn can be easier. A stock that is down 40% that do not pay dividends is very tempting to sell. On the other hand, there is a motivation to hold a dividend stock for its dividend payment.
- Mature and Established Companies
Most of dividend paying stocks are established companies that have big scale and a lot of customers that know about the product or service. The luxury of having consistent customers trusting a product creates some barrier to future competition.
Disadvantage
Dividends are money paid from a company. This will decrease the amount of cash a company have on its balance sheet. The company has to make enough profits to pay out dividends. Otherwise, a company may have to take debt just to afford dividend payments.
- Limited Upside
Growing companies tend to pay zero dividends to reinvest its profit for future growth. A company that is growing a lot in revenue/sales every year tends to lose money, so it choose to not pay dividends.
Dividend stocks usually have limited upsides since they prefer to pay out some dividends instead of reinvesting profits to grow the company. Dividends can be a sign that a company do not have other projects to grow its revenues or profits.
With the dividends a company is paying, the amount of cash on their balance sheet decreases. There is lesser opportunity for growth with the amount of cash decreased.
- Dividends can be cut
On the recent stock market crashes of 2008 and 2020, a lot of dividend stocks have cut dividends. Lots of companies were losing money and there was a lot of uncertainty of how long they will lose money.
CCL is an example of a stock that removed its dividends on March 2020. Since they’re business cannot operate, they are losing money to keep maintain their cruises. There is little to no revenue at the time. CCL cut its dividends to zero.
Dividend stocks can cut or remove its dividends anytime they wanted. This usually happens when a company starts to lose money, or when a company is not generating enough profits to pay out dividends. Also, this happens when a company nears bankruptcy.
Stock market and economy crashes can cause companies to have lesser revenue and customers are not buying as much. A lot of stocks cut its dividend during these times.
- Taxes on dividends every year
Capital gains on a stock will only be taxed on the tax year it is sold. For example, a stock was bought on 2010 and sold on 2017 for $2,000 profit. In this example, there would be no taxes from 2010 to 2016. The $2,000 capital gains will be declared as income for tax year 2017.
Dividends are taxed on the tax year it is received. Dividend taxes cannot be deferred to future years, unless it is on a registered account like TFSA or RRSP.
How much do I need to invest to make $100 a month in dividends?
A high dividend stock that have little to no revenue growth usually pays around 4% dividends. To earn $100 a month from 4% dividends per year, a person has to invest around $30,000 on high dividend stocks.
On the other hand, dividend growth stocks usually pays lower dividends to compensate for potential growth. Assuming a 1% dividend yield, a person has to invest around $120,000 to receive $100 a month on dividends from dividend growth stocks.
To make $1,000 a month ($12,000 per year) from dividend stocks, a person has to invest around $300,000 assuming a 4% dividend yield. Dividend yield higher than 7% is considered a red flag, and it is recommended to do more research to make sure earnings are sustainable to pay 7% or more dividends.
2. Research to evaluate dividend stocks
A good dividend stock is where profits of the company is enough to pay its dividends. After all, dividends are cash payout from a company. So, decreases how much cash a company has, potentially putting a company in a worse financial shape.
There is no one measure to determine whether a stock is a good or bad investment. These factors below will focus more on dividend stocks and basic measures that can be found on a quick google search or on common financial websites such as yahoo finance.
These are few of the most basic factors to identify whether dividends from a stock is sustainable or not:
Payout Ratio
Payout ratio is how much of a company’s earnings is paid to shareholders in form of dividends. Payout ratio is arguably the most common and useful way to identify if dividends of a stock is sustainable or not.
Let us say a company earned $5 earnings per share on a year. A payout ratio of 50% would mean that this company paid $2.50 in dividends (50% of $5). If the company choose to pay all of its $5 earnings in dividends, it would have a payout ratio of 100%.
Generally, a lower payout ratio is better for dividend stocks. This means that a company did not pay out all of its profits. A payout ratio higher than 100% is not ideal since its profits is not enough to pay out dividends. A payout ratio lower than 100% means that a company is generating enough profits to pay dividends.
If profits is not enough to afford dividends, a company may have to take more debt to complete the dividend payout. A payout ratio higher than 100% has a higher risk that its dividends may be cut or removed in the future since its not generating enough profits to afford its dividends.
A payout ratio of around 50% to 70% may be the sweet spot so that a company may keep some of its profits to use in the future. A lower payout ratio is generally better.
Balance Sheet
The balance sheet of a company shows its equity, assets and liabilities. There are a lot of ways to analyze a balance sheet. For this article, we are going to stay at the basics.
Stocks listed on the NYSE, TSE, and the NASDAQ are required to declare its balance sheet and a lot of other information every 3 months through its 10-Q. Also, they are required to file a comprehensive report every year known as a 10-K. These reports are available publicly.
The “total current assets” should be greater than “total current liabilities”, and the “total assets” should be greater than “total liabilities” for a stock to be in a good financial condition, especially for dividend stocks.
The greater the difference between the assets and liabilities, the better financial situation a company is in.
The balance sheet of a company can also determine if it can withstand potential downturn in the future. Companies that have little assets compared to its liability have a higher risk to bankruptcy, especially during a stock market crash.
Companies that have great balance sheet where assets are much greater (double or triple) than liabilities may be able to keep paying dividends even in times of recession.
Dividend History
Looking a 5 or more years of dividend history of a stock is helpful to know whether it has been reliable in the past. A stock that constantly raise dividends over time is likely to keep increasing it, provided it has a good balance sheet, and consistent customer base.
Having a dividend get cut or removed for a quarter or two during the recent stock market crashes of 2000, 2008, and 2020 may be understandable since the economy was falling apart at the time. But a long dividend cut of 3 years or more can indicate that it will cut again in the future.
A dividend stock that still managed to continue paying dividends during such times shows resiliency of the company.
Beta of a stock
The beta of a stock only considers how volatile a chart of a stock is. The lower the beta of a stock, the more flatter its stock price chart is, and not much price movement occurred. A higher beta means a stock has moved a lot, either upside or to the downside.
For example, a stock that stayed relatively flat and stayed at $50 to $60 range for 5 years will have a low beta. Another stock that moved from $10 to $100, back to $50, and have a regular 30% or more price swings will have a high beta number.
Beta of a stock can be found on yahoo finance or similar sites.
For the most part, people prefer a stable dividend stock prices. A beta of 0.5 or lower is ideal for high dividend stocks while a beta of around 1 is good enough for a dividend growth stock. A beta of less than 1 is considered to be less than average on the stock market.
Note: The 0.5 beta is more of an estimate. For the most part, beta only takes into account the price movement of a stock and do not take into account its fundamentals like the balance sheet, strengths of a company, customer base, etc.
P/E ratio
Price to earnings ratio is one of the most common measures of a stock. P/E ratio is how much an investor has to pay at the current price per $1 of earnings. For example, let us say a stock is trading at $100 and the company reported $5 of earnings per share.
In this example, the P/E ratio would be 20 (100 divided by 5). To purchase a stock, an investor has to pay $20 for every $1 of earnings per year on this stock.
Note: Evaluating through the P/E ratio is very similar to payout ratio. We can determine if the profits of a company is enough to pay its dividends by using the P/E ratio, so it does the same thing as payout ratio in this topic of dividend stocks.
However, P/E ratio is the most common measure of a stock. This P/E ratio section is more of an optional read for this article.
A high P/E ratio (50 or more) means that investors are willing to pay higher prices for every $1 of earnings, and investors expects high future growth from a stock. A low P/E ratio (10 or less) means a stock is cheap and investors are expecting that a company’s revenue and profits is going to be either flat or lower in future years.
Generally, a good dividend stock is when its profits is enough to pay its dividends. That means a lower P/E ratio (low price, high earnings) is ideal for a dividend stock. A P/E ratio of around 15 to 25 is good enough to afford a dividend yield of around 4%.
Since earnings (E) is used to compute for the P/E ratio, we can determine how much dividend yield a company can afford by only using its earnings.
Using the same example of $5 earnings and a stock price of $100, the highest dividend a stock can afford by only using its profits is a dividend payment of $5. If this stock paid $5 in dividends, it paid out all its profits ($5 earnings).
Thus, a P/E ratio of 20 (100/5) can afford a dividend yield of 5% (5/100). By inversing the P/E ratio, we can get the maximum dividend a stock can afford by only using its profits and not going into more debt.
Maximum dividend a stock can afford on each P/E Ratio
| P/E ratio | Maximum dividend yield |
| 5 | 20.00% |
| 10 | 10.00% |
| 15 | 6.67% |
| 20 | 5.00% |
| 25 | 4.00% |
| 40 | 2.50% |
| 50 | 2.00% |
Earnings of a company changes every year. The P/E ratio and payout ratio only takes into account the earnings in one year. In real life, no one knows how much profits a company will earn in the future.
If a company cannot make enough profits to pay its dividends on one year, it is very likely that dividends may be cut or removed in the future.
P/E ratio of 10 or lower means a stock is very cheap. This can also be a red flag since investors are expecting earnings to fall in the future for valuing a stock very low.
For such extremely low P/E ratio stocks, checking the earnings and revenue history of the last 5 years and the next 5 year analysts estimates is helpful. If earnings are set to decrease or negative earnings (loss) for future years, then low P/E ratio is justified and is a red flag.
Note: There are a lot more factors one can use to evaluate a dividend stock. These are the most basic ones to use. These are not financial advise, visit a professional for professional advise.
3. Diversification of dividend stocks
There are two ways to diversify dividend stocks: buying 5 or more dividend stocks or by investing on dividend stock ETFs
Dividend stock ETFs are funds that tracks the returns of 50 or more dividend stocks inside it. Thus, if one of the dividend stocks have cut dividends or have gone bankrupt, it would not affect the returns as much.
Diversifying through ETFs can spread out the risk of investing. Here are a few of dividend stock ETFs in Canadian dollars. Investing platforms usually charge 1-2% exchange rate fee to US dollars. These ETFs can avoid those fees.
For US dividend ETFs, Vanguard ETFs are one of the most popular ones.
3 Dividend Stock ETFs in Canadian dollars
| Dividend ETF (CAD) | CDZ | XEI | XDV |
| Dividend Yield | 3.26% | 3.77% | 3.83% |
| P/E Ratio | 19.4 | 18.5 | 16.1 |
| No. of Stocks | 86 | 74 | 29 |
| Management Fees | 0.66% | 0.22% | 0.55% |
| Dividend Payment | Monthly | Monthly | Monthly |
Note: These data are taken as of June 8, 2021.
Number of stocks
ETFs are usually made up of a group of stocks inside it. For example, XEI is made up of 74 dividend stocks inside it. On the holdings section of their info page, a few of the stocks inside XEI are RBC, TD Bank, TC Energy, and Suncor Energy.
Dividend Yield
These 74 stocks inside XEI influences the returns and dividends of XEI. If some stocks inside XEI have cut or removed their dividends, the dividends paid by XEI will also decrease. At the same time, XEI dividends will increase when the stocks inside have increased their dividends.
Dividend yields and interest rates are expressed per year. That goes on credit card, car loans, savings account rates, and even dividend rates listed.
For example, assume an investment of $10,000 has a dividend yield of 4%. From this, we expect $400 every year, and $33.33 dividend payment per month.
Since dividend ETFs are made up of 20 or more stocks, dividend yield changes when the stocks inside it increased or decreased their dividend payments.
Management Fees
ETFs charge a fee that they automatically reduce on the price of ETF. Common funds like S&P 500 ETFs charges the lowest fees among ETFs of around 0.10% per year or less. Dividend ETFs usually charges around 0.50% per year. Typically, more diversified ETFs charges the higher fees.
Let us say an ETF has 100 stocks inside it. Assuming the stocks inside it have gone up 10% on a year and they charge 0.50% management fees, the actual ETF would be up around 9.50% compared to last year because of the 0.50% fees.
4. Open an Investing Account
In Canada, the most common investing platform that offers dividend stocks and ETFs are Questrade, Wealthsimple Trade, and the big banks like TD and RBC Direct Investing.
In US, they have online brokerages like Webull and Robinhood, and US big banks like Charles Schwab, Fidelity, and TD Ameritrade.
- $4.95 min to $9.95 max (1 cent per share) commission fees for buy or sell trade. (Ex. buying 2 shares =$0.02, result to minimum of $4.95)
- Free ETF buys
- $4.95 min to $9.95 max (1 cent per share) for ETF sell
- $9.95 plus $1/contract on option trades
- 2% exchange rate fee to US dollar
- Founded on 1999
How to Buy and Sell Stocks on Questrade
Big Banks
- Typically charges $9.95 flat commission fee for every buy or sell trades ($9.95 USD for US stocks, $9.95 CAD for CAD stocks)
- 1-2% exchange rate fee to US dollars (varies every bank)
- $100 annual inactivity fee if account holder do not trade 3 or more times in a quarter. This fee can be waived if some conditions are met like for $15,000 or more portfolios and more (depends every bank)
- Opening an account can take a few days. Filling up online takes an hour, then they may require to send print it and send physically to a back or mail to their main branch (depends every bank).
- $9.95 plus $1.25 on option trades
Buy and Hold Portfolio
I chose Wealthsimple Trade and ETFs in Canadian dollars to avoid the exchange rate fee.
- April 2021 – bought $500 on XEI (Dividend ETF in CAD) and $500 on VSP (S&P 500 ETF in CAD)
- May 2021 – Bought $200 more VSP (S&P 500)