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Dividend Stock Checklist

by Harry Domash

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 share price drop as well.

Here are seven simple checks to help you pick the best dividend candidates. You can find the required data on many financial sites. I'll use MSN Money (money.msn.com) to demonstrate the process.

1) Start With Dividend Yield   
Since dividends are the point, stop here if the stock isn’t paying a sufficient yield. How much is enough? That depends on your needs of course. Here are my rules of thumb (MSN Money Summary report). 

Action: Disqualify regular common stocks stocks with less than 3.5% dividend yield. For categories that are not taxed at the corporate level such as REITs, MLPs, and BDCs, require a minimum 4.5% yield.

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

2) Avoid High Debt  
Cash-strapped firms may view dividend payouts as a luxury they can do without. Companies typically get into that position because they are carrying too much debt. Thus you can minimize the chances of a dividend cut by sticking with relatively low-debt firms.

The total debt/equity ratio (D/E) compares the total of short- and long-term debt to shareholders equity (book value). Ratios of 0.0 signal no debt, and the higher the ratio, the higher the debt. What' constitutes high debt varies with industry. Typically, industries with steady and predictable cash flows, such as utilities carry higher debt that firms in more volatile industries, such as semiconductor makers.

Rather than setting an arbitrary maximum D/E ratio, it's better to compare a firm to others in the same industry (Select Fundamentals, then Key Ratios, and finally, Financial Condition).

Action: stick with firms with D/E ratios below their industry average. 

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

3) Cash Generator
Operating cash flow is the money that moved into, or out of, a firm’s bank accounts resulting from its main business. Sometimes companies that report positive earnings are, in fact, losing money when you count the cash. A firm has to be generating positive cash flow to fund its dividends. The easiest way to verify positive cash flow is to check the price/cash flow ratio, which can only be positive when cash flow is positive (Select Fundamentals, then Key Ratios, and finally, Price Ratios).

Action: Disqualify candidates with negative operating cash flow (negative price/cash flow ratio).

4) Avoid Cheap Stocks 
Most quality stocks change hands at prices well above $5. When stocks trade below that level, you can assume that many market players see fundamental problems ahead. Right or wrong, stocks trading below $5 are riskier than more expensive stocks. Successful dividend investing is about minimizing 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.” For a variety of reasons, analysts generally avoid issuing “sell” ratings. Instead, they typically rate stocks “hold” that they think should be sold. The ratings displayed on financial sites are a compilation, or average, of all analysts’ ratings for a specific stock. To facilitate the compilation, they assign these numeric values to each analyst rating:

• Strong buy = 1

• Buy = 2

• Hold = 3

• Sell = 4

• Strong Sell = 5

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. Dividend investors shouldn't bet on that coin toss (Analysis report). 

Action: Disqualify stocks with consensus analysts’ ratings from 2.6 to 5.

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 (Select Fundamentals and then Company Report to see the 5-year dividend growth rate).

Action: Disqualify stocks with less than 5% average annual 5-year dividend growth.

7) Forecasting the Future
As pointed out earlier, the best dividend stocks are those that raise their dividends while you hold them. How do you spot such stocks?

Since, in the end, earnings drive dividends, look for stocks that analysts expect to grow earnings over the next few years. Analysts’ long-term average annual earnings growth forecasts are a good resource for this information.

For dividend stocks, your best prospects are firms expected to grow earnings between 5% to 14%, on average, annually. Slower growers won’t generate much dividend growth. Conversely, stocks with 15% or higher expected annual earnings growth rarely make good dividend candidates.  They are usually richly priced and subject to earnings shortfalls, which sinks the share price (Select Earnings and then Earnings Growth Rates. Use the Next 5-Years column). 

Action: Disqualify candidates with less than 4%, or more than 15%, forecast long-term average annual earnings growth.

These seven tests will help you to identify dividend-paying candidates worth pursuing. But passing these tests doesn't guarantee that you'll make money owning the stock. You still need to research the stock in depth. The more you know about your stocks, the better your results.

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