Dividend Stock Basics  

Here’s a novel idea: Buy stocks that pay you to own them! They are called dividend-paying stocks, and you make money, even if they don’t go up much.

Better still, stocks with solid dividend prospects don’t go down as much as other stocks, because when they try, the resulting dividend yield boost attracts more buyers.

Dividends Defined
Dividends as used here, means cash dividends that companies pay on a quarterly basis. We’re not considering stock dividends sometimes used to implement stock splits or company spin offs, or one-time cash payments.

Normally, your broker adds your received dividend to your cash account. However, some offer automatic reinvestment plans. With these plans, your dividends are used to purchase additional shares, even if the dividend equates to only a fraction of a share. 

Dividend Stock Types
Utilities frequently come to mind when talk turns to dividends. But banks and a variety of manufacturing and service companies also pay significant dividends. These stocks pay dividends equating to as high as 4.5% annual yields. Troubled stocks sometimes pay higher dividends. reflecting the market’s concern about the firm’s future prospects.

The maximum income tax on these dividends will be 15%.

Definition of Dividend Yield
The estimated dividend payouts over the next 12 months divided by the price you pay for the shares. For instance, the yield would be 5% if you pay $20 per share for a stock expected to pay $1 per share dividends over the next 12 months.

Many investors look to tax-advantaged entities such as real estate investment trusts (REITs), Master Limited Partnerships (MLPs) and Business Development Companies (BDCs) for higher yields. REIT’s MLPs, and BDCs do not pay corporate income taxes as long as they pay out most of their earnings to shareholders. However, their shares trade on the major exchanges, the same as any other stock. Their dividend yields typically range between 4% and 10%, and in some instances, even higher. Dividends paid by firms such as REITs that do not pay income taxes are taxed as ordinary income.

REITs, MLPs & BDCs
REITs are required to invest only in real estate. There are two types of REITs, property REITs and mortgage REITs. Property REITs own real estate such as shopping centers, office buildings, residential apartment complexes, etc. Mortgage REITs do not own property, instead, they invest in mortgages.

MLPs are managed by general partners. Other investors are termed unit holders (shareholders) and are limited partners. MLP tax advantages appeals to major energy companies and many have transferred their petroleum and natural gas pipeline assets to MLPs that they control as general partners. MLPs offer a potential tax advantage to you because a portion of their payouts, termed distributions, can be tax-deferred. However, they may not be suitable for tax-sheltered accounts, so consult your tax advisor before putting them into IRAs, 401k plans, etc.

BDCs are special purpose entities formed to provide financing and management assistance to small- and mid-sized companies.

Picking the Best Dividend-Payers
Successful dividend investing requires finding candidates with: 1) minimal risk of dividend cuts and/or other negative events, and 2) a high probability that the dividends will increase while you own the stock.

You win two ways when the dividend increases. First, the yield on your initial investment goes up with the dividend, and even better, the dividend increase often propels the share price higher. Conversely, a dividend cut shrinks your yield and often precipitates a drop in the share price as well.

Here are seven simple checks to help you pick the best dividend candidates. You can find the required data on sites such as Yahoo! (finance.yahoo.com) or MSN Money (moneycentral.msn.com).

Dividend Stock Checklist

1) We’re Here to Get Paid   
Dividends are the point of this exercise, so stop here if the stock isn’t paying a decent dividend. How much is enough? That depends on your needs of course. Here are my rules of thumb. 

Action: Disqualify general stocks with less than 3% dividend yield. Disqualify REITs, MLPs, and BDCs yielding less than 5%.

Of course higher is better, as long as the dividend is safe, which leads us to the issue of financial strength.

2) Stick With the Rich Guys  
Cash-strapped firms may view dividend payouts as a luxury they can do without. Financial problems start with too much debt, so you can avoid the problem by sticking with low-debt companies.

The financial leverage ratio, which is total assets divided by shareholders’ equity (book value), is a good all purpose debt measure. A leverage ratio of 1.0 means that the company has no debt, and the higher the ratio, the more debt.

The average leverage ratio of all companies making up the S&P 500 Index is around 5. Ratios below 2 equate to very low debt, and those above 9 signal very high-debt.

Action: stick with firms with below-average debt, that is, with leverage ratios below 5.0, and lower is better. (Find the Leverage Ratio on MSN by clicking on Financial Results, then Key Ratios, and finally select Financial Condition)

This rule does not apply to banks, savings and loans, and similar institutions. Borrowed money is their inventory, and most are high-debt by definition. However, the U.S. Government carefully monitors all U.S.-based financial institutions, and solvency is not a significant issue.

Minimizing risk is key to successful dividend investing, and the following three checks help to rule out high-risk stocks.

3) Stay on Main Street
Most stocks of interest to U.S. investors are listed on the New York, American, or Nasdaq exchanges. However, some don’t qualify and are listed on the Bulletin Board, Pink Sheet or foreign exchanges. The reasons vary. The stocks may not meet minimum trading price requirements, the company may not have filed required SEC reports, or it may not have sufficient assets. These stocks may represent quality companies, but the factor preventing their listing usually translates to above normal risk.

Action: Disqualify candidates not listed on the NYSE, AMEX, or the NASDAQ.

4) Avoid Hammered Stocks 
Most quality stocks change hands at prices well above $5. Stocks trading below $5 have usually been hammered down to that level by bad news. Often, their very survivability is in question. Dividend investors don’t need that risk.

Action: Disqualify stocks trading below $5

5) Pay Attention to Stock Analysts
Since stock analysts are notorious for their overoptimistic buy/sell ratings, it pays to take heed when they actually do recommend selling a stock.

About Analysts’ Ratings
Analysts assign ratings to stocks that equate to gradations of “buy,” “hold,” or “sell.” Analysts, for a variety of reasons, are disinclined to issue “sell” ratings. Instead, they often rate stocks “hold” that they think should be sold. The ratings displayed on MSN Money and other sites are a compilation, or average, of all the available analysts’ ratings for the stock. To facilitate the compilation, the ratings are assigned numeric values:

Strong buy = 1

Buy = 2

Hold = 3

Sell = 4

Strong Sell = 5

A 2.0 consensus rating means that the average of the compiled ratings is 2.0, but doesn’t necessarily mean that any one analyst rated the stock at “buy.” For instance, if two analysts rated a stock, one at “strong buy” (1.0) and the other at “hold’ (3.0), the result would be a 2.0 consensus rating.

Consensus ratings of 2.6 to 5 tell you that most analysts are rating the stock at “hold,” which translates to “sell,” or worse. They may be wrong, but they may also be right. As a dividend investor, you don’t want to bet on that coin toss.

Action: Disqualify stocks with consensus analysts’ ratings from 2.6 to 5. (Find analyst ratings on MSN by selecting Analysts Ratings and then Current Mean Recommendation). 

The following two checks help you to identify stocks with good dividend growth prospects.

6) History Teaches  
Some companies consider dividend growth a high-priority, while others prefer to use the money elsewhere. You can tell which is which from the firm’s dividend growth history.

Action: Disqualify stocks with less than 5% average annual dividend growth, and higher is better. (On MSN, the 5-Year Dividend Growth is listed on the Dividend Rate row in the Financials section of the Company Report)

7) Dividends Don’t Fall Out of the Sky 
Since dividends ultimately come from earnings, dividends can’t grow if earnings don’t. So dividend investors need to know whether a company’s future earnings are headed up or down. Analysts’ long-term average annual earnings growth forecasts are a good resource for this information.

Your best prospects are companies expected to grow earnings in the 5% to 14%, or so, range. Slower growers won’t generate much dividend growth. High earnings-growth stocks are usually richly priced, subject to earnings shortfalls, and thus rarely make good dividend candidates. 

Action: Disqualify candidates with less than 4%, or more than 15%, forecast long-term average annual earnings growth. (Find the long-term forecast earnings growth on MSN by clicking on Earnings Estimates, then select Earnings Growth Rates, and look in the Next 5-yrs column)

These seven tests help you to identify dividend-paying candidates worth pursuing. But these tests are just a start. You’ll be a better investor if you learn as much as you can about each stock before you invest.