Many investors pay too much focus on the dividend yield of a company when investing in income stocks. The yield only tells us 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 going forward.
Let’s look at the next two questions investors should ask of a dividend company when they evaluate it (the first two questions can be found here).
Question 3: Can it continue to pay dividends at its current rate?
Apart from the ensuring that the company has enough earnings to cover its dividend, investors need to assess if the company can grow earnings in the future. This will determine if it can continue to pay dividends at its current rate or even increase its dividends.
If the company’s business outlook looks rather bleak, it might be a red flag for income investors. It is highly likely that earnings might drop in the future, resulting in lower dividends.
In my view, firms need to grow their businesses even if they want to continue to pay the same amount of dividends every year. As the years go by, inflation causes expenses to rise. This means that the company must increase its revenue to continue paying similar dividends.
Question 4: Has dividends increased over the years?
The last question that income investors should ask is that of dividend growth. This is essential because as I mentioned above, inflation causes the value of money to decrease year after year. What this means is that at the minimum, the company should increase its dividends in line with the inflation rate. By increasing dividends by the same amount as the inflation rate, the company is at least ensuring that the value of the dividend is similar.
However, if the dollar value of the dividend stays the same, it means that investors are actually getting less dividends on a yearly basis. If that is the case, the investors need to assess if the company has a history of increasing its dividend at a fixed interval, such as every three years, instead of every year. If so, these increases should more than compensate for the 3-year inflation rate.
The Foolish takeaway
We have looked at four questions that investors should ask when buying dividend stocks. Each of these questions is essential to get an accurate picture of the company and its ability to pay a stable and growing dividend.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.