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2 Questions to Ask When Evaluating Dividend Stocks

The Singapore market is well known for its high dividend-paying firms. One such group is those of real estate investment trusts (REITs). With dividend stocks being popular in the city-state, how should investors evaluate such companies?

One of the biggest mistakes an investor can make is being too fixated on the dividend yield of a company. This is often an issue because the yield only tells you about the past and not the future. While the dividend payments might have been high in the past, it does not automatically result in high dividend payments in the future.

Let’s look at two questions investors should ask of a dividend company when they evaluate it.

Question 1: Do earnings sufficiently cover the dividend payments?

For a company to pay dividends, it needs to make money; that’s pretty obvious. Therefore, the first check investors should make is to ensure that the company’s earnings are sufficient to cover its dividend payments easily.

For REITs in Singapore, the payout rate is usually 90-100%. This means that the REIT is paying out close to all its earnings as dividends. In such a situation, it becomes even more important to evaluate the stability of the business or rental income.

For companies other than REITs, the payout ratio should be checked thoroughly. Companies with a payout ratio of below 75% are usually deemed to be relatively conservative in my view. Investors should keep in mind that companies that pay out 100% or more of their earnings as dividends should be seen with some scepticism, unless they are just one-off payments.

Question 2: How stable has past dividends been?

The next factor investors should look at is the stability of the dividend. Most investors who buy dividend stocks do so for the opportunity to get recurring income from these stocks. In such a case, isn’t the stability of the dividend important?

When looking at the dividend history, investors should keep a keen eye on dramatic cuts in dividend or the worst case, a missed payment. Let’s have a quick look at what could cause these.

For a REIT, a drop in the payout could be reflective of poor demand from its properties, resulting in lower rents. This could mean that the property is no longer competitive and thus, is unable to command high rental income moving forward, unless the manager takes steps to improve the property.

Another reason for a drop could be due to the sale of a property. In such a case, investors need to evaluate what the manager does with the sales proceeds. If it is reinvested into another property, the rental income should be able to compensate for the lost income.

For companies other than REITs, a drop in dividend could be reflective of challenging business conditions. In such a case, investors need to re-evaluate the earnings moving forward. Another reason for a drop in payment could be due to a revision of the company’s payout policy. If this was the case, management should have a clear explanation for the reduction.

The Foolish bottomline

The two points above are just the starting points from which investors should evaluate dividend stocks. The questions will ensure that investors pay close attention to a company’s or REIT’s ability to pay a stable dividend, avoiding any potential pitfalls in the meantime.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.