How to Analyze a Company's Dividend Sustainability

Investing in dividend stocks can give you a steady income and growth without the headache of dealing with real estate or settling for lower returns from safer investments. The money from dividends might even cover your living expenses and make retirement more comfortable. Dividend stocks are great for long-term goals, but every investment has its risks. Dividend aristocrats have bumped up their dividends for 25 years straight, but other companies have slashed theirs or gone out of business. Even if a company stays afloat, a dividend cut can be rough for retirees who depend on that income. Learning how to check out a stock's dividend can help you find good opportunities and avoid risky bets. Analyzing a dividend stock means looking beyond just the current yield and stock price. Spending some time on this before choosing a stock can keep your financial plans on track.

Reasons to Love Dividends

With today's low interest rates, it's tough to get enough income from investments to retire comfortably. Take a retired investor with a million bucks. Ten years ago, a portfolio of 10-year U.S. Treasury bonds would give nearly risk-free 4.5% in income per year. Now, that same money would only bring in about 2.4%probably not enough for retirement. That's why more investors are chasing dividend-paying stocks for higher yields. The catch is, in the hunt for high yields, they're buying lower-quality company stocks, adding more risk to their investments. So, how can investors keep their investments safe? There are a couple of simple calculations to check a company's dividend sustainability.

Find the Stock Valuation

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After you look at the company's and the dividend's sustainability, the next step is to check the valuation. Some dividend stocks have great growth rates and high yields but get overlooked because of a high valuation. You can use different valuation metrics to figure out a stock's real value, but most dividend investors look at the price-earnings (P/E) ratio. You get the P/E ratio by dividing the share price by earnings per share (EPS). For example, if a stock is $100 per share and the annual EPS is $4, the P/E ratio is 25. If you like the stock but think it's too pricey, you can set a fair price to buy. If you think a P/E ratio of 20 is fair for $4 EPS, you'd wait for the stock to drop to $80 or below before buying.

When checking the P/E ratio or any other metric, it is important to compare similar companies. Using a tech company to decide if a bank stock is fairly valued can lead to wrong conclusions since they are in different industries. Valuations help you see if a company is fairly priced, but they don't predict future changes. Keeping an eye on a company's fundamentals can show you its long-term potential.

Examine Earnings Growth and Year-Over-Year Revenue

Seeing how a company grows over time can give you a good idea about how stable its dividends might be. Sure, past performance doesn't guarantee future success, but it can show you the company's trend. If a company keeps increasing its revenue and earnings, it's more likely to keep paying dividends. A company that consistently boosts its revenue and earnings by more than 10% each year usually has enough space to grow and support its dividend. But if a company's growth is slowing down, its dividends might be at risk. For example, if a company's earnings growth dropped from 20% to 5% over a few years, it's worth checking if the dividend might be in danger.

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Look for the Dividend Payment History

Analyzing stocks well means looking at multiple factors, not just one. While the payout ratio is useful, you should also check out the company's dividend payment history. This history shows how often the company pays dividends and how much they increase them. Most companies raise their dividends each year to reward shareholders and show confidence in their business. Some companies with strong financials can increase their dividends by more than 10% each year, while others have lower growth rates. When companies hike their dividends, it's a strong statement of their confidence in their current and future performance. Dividends are straightforward; you can't fake them or use accounting tricks.

Keep an Eye on the Dividend Payout Ratio

Companies don't have to pay dividends every quarter, but once they start, investors usually expect them to continue. Companies can lose a lot of investors if they stop their dividends, so they try to keep paying if they can. While some big events can force a dividend cut, other cuts can be easier to predict. Investors can check a company's dividend payout ratio and history to see if the dividend is sustainable. The payout ratio shows what percentage of earnings is paid out as dividends. You can figure this out by dividing the annual dividend per share by the annual earnings per share. For example, if a company has a $2 annual dividend per share and $5 annual earnings per share, the payout ratio is 40%. A 40% ratio suggests the dividend is sustainable. But if it's over 70%, you might need to dig deeper to see if the dividend is safe. Remember, dividend payouts can vary a lot between industries. For instance, master limited partnerships (MLPs) and real estate investment trusts (REITs) often have higher payouts. As part of a deeper analysis, it's a good idea to look at the company's cash flow and check if any decline in business fundamentals is just a temporary issue.

Find Out The Dividend Investing Style

When it comes to dividends, most folks are either into income or growth. If you're an income investor, you care more about cash flow than how much the stock price goes up. You're looking for stocks with high dividend yields. Price appreciation is a nice perk, but the current dividend is your main focus. Think of stocks like AT&T and Verizon. They have high dividend yields, but their businesses aren't growing that fast. On the flip side, growth investors care more about how much the stock can appreciate and grow over time. These stocks might have lower yields but have more potential for the dividend to increase. Look at Apple and Broadcom. Their yields are lower, but they've given better returns over the past decade when you factor in price appreciation. Once you know what you're aiming for, it's easier to figure out if a stock fits your portfolio. Setting criteria helps you weed out stocks that don't make the cut.

Chalk Out Long-Term Goals

Before diving into any stock and its dividends, make sure you know what you want from your portfolio. Investing without a clear plan can mess things up. Dividend investors are all about cash flow. The goal should be to build a portfolio that pays enough dividends to cover your living expenses in retirement. If your dividends cover most of your expenses, you won't have to sell shares to fund your lifestyle.

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Conclusion

Remember, investing works best when you find solid long-term investments that grow over decades. Just because a company offers a dividend today doesn't mean it'll keep doing so forever. Dividend yield matters, but make sure those dividends are sustainable. Buying a stock just for its high dividend today doesn't guarantee it'll be a good investment tomorrow. These are just a few ways to use a company's financial statements to check if its dividends are sustainable.

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