How to Invest in Dividend Stocks: 12 Steps - wikiHow

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How to Invest in Dividend Stocks

If you have a long-term investment horizon of at least ten years, your best investment is not mutual funds, ETFs, growth stocks, bonds, or gold, but a diversified portfolio of high quality dividend stocks. Here are the steps to build your investment portfolio to achieve the best long term returns.

Steps 1
Understand that stock return = dividend yield + share price growth. For example, a company that pays a 5% dividend yield and appreciates by 5% every year has an annualized 10% total return. High quality is necessary to ensure that the dividend will last and will grow at a satisfactory rate. Start with a list of candidate stocks. With thousands of stocks on the exchange, here are a few good ways to narrow down to a more manageable list: Start with the 30 stocks that make up the Dow Jones Industrial Average (DJIA). These are large, leading American companies in their respective industries. Many of them have the high quality characteristics required for long term performance, although many others do not meet quality criteria for investment. This list is important because it is a widely used benchmark for the stock market, so you should become acquainted with it. Each stock in the list must be investigated further, as detailed below, to determine whether or not it meets investment criteria. Use an online stock screener to screen for stocks with at least 100 million market cap, dividend yield at least 150% of the S&P 500 (e.g. if the S&P 500 pays 2% dividend yield, look for at least 3% dividend yield), return on equity (5-year average) at least 15%, long term debt to equity ratio less than 1, interest coverage at least 5%, and 10-year earningper-share (EPS) growth at least 5%. This should narrow down the list of candidate stocks significantly. A recent screen using these criteria generated a list of 46 stocks.[1] Many of the stocks on this list also fail to meet criteria as quality dividend stocks; additional research as detailed below is necessary. Look at the list of holdings of mutual funds that invest primarily in quality dividend stocks, such as the Vanguard Dividend Appreciation Fund.[2] This list is high yield for finding quality dividend stocks that meet investment criteria detailed below. Look at the list of dividend achievers: stocks that have a history of raising dividends. You can find this list by doing an internet search, for example, http://www.indxis.com/DividendAchievers.html . Look at the list of dividend aristocrats: stocks that have consistently increased dividend every year for at least 25 years. You can find the most updated list by doing an internet search. This list of blue chip stocks is likely the very best and highest yield for finding quality dividend stocks that meet the investment criteria set forth below.

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From the list of candidate stocks, use an online financial website such as money.msn.com to investigate each company. Look at the financial statements over the past 10 years, and immediately eliminate from further consideration any company that shows EPS loss in any of the past 10 years. For example, in money.msn.com, type in the stock ticker symbol (e.g. "T" for AT&T), on the stock page click on the "10-year summary" tab located at the bottom of the left panel, and look for any EPS deficits. For AT&T, there is red ink for the year 2008, so it must be eliminated from further consideration. If a company does not have at least ten-year history of earnings, do not invest in it. It has not yet demonstrated an ability to generate consistent earnings and is therefore too risky to be considered an investment. Insist on financial strength, which is indicative of high quality. Look at the balance sheet and income statement for the following key measurements of financial strength: Low debt to equity ratio (should be less than 1, and no debt is better than low debt); High interest coverage (net earnings at least 5 times interest expense on the annual income statement); No preferred stocks listed on the balance sheet (preferred stocks are more costly than bonds to the issuing company and are generally resorted to by weak companies that cannot raise money otherwise). Ideally, but not absolutely required, total current assets should exceed total current liabilities, to make sure that the company does not run into any immediate cash flow problems. A current ratio (total current assets/total current liabilities) greater than 2 is desirable.

Look for uninterrupted dividend payment for at least the past 10 years, preferably 20 yearsthe longer, the better. You can get this information from the company's website. Furthermore, the dividend should be increasing every year, or at least every 2-3 years. Stocks that do not pay dividends or do not fulfil these criteria should be rejected. Look for high return on equity. A 5-year average of 15% should be the minimum, and 20% or more is preferred. Look for dividend growth at least 5% per year for the past ten years, the higher the better. Keep in mind, however, that a high dividend growth (greater than 30% for example) may be unsustainable. To provide a margin of safety, look for payout ratio (ratio of dividend to net earning) less than 40%. The low payout ratio rule does not apply to utilities, REITs, or master limited partnerships (MLPs). Look for rising earnings-per-share (EPS) and rising sales during the past ten years. Sales growth fuels earnings growth, and earnings growth fuels dividend growth. Without fuel from sales and earnings growth, dividend growth will not last. Of the companies that fulfill all the criteria above, study them further to ensure that they have a durable competitive advantage to ensure their continued profitability. Companies that sell non-durable goods, such as Johnson & Johnson (drugs), Procter & Gamble (household care products), McDonalds (fast food), and Phillip Morris (cigarettes), tend to remain profitable during both recessions and prosperity.

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Rank the list of investable stocks from lowest to highest P/E ratio. Use average earnings over past three years for the calculation to minimize the effect of any aberrant earning (for example, a recent large non-recurrent unusual expense or income). Also calculate price-tobook (P/B) ratio and price-to-sales (P/S) ratio. The lower these ratios, the better. Every two to three months, invest equal sums in three to five companies with the lowest P/E ratios. Diversify your stock holdings to include many different industries. You should have representative stocks in Healthcare, Consumer Staples, Energy, Financials, Technology, Industrials, Telecommunication, Utilities, and REITs. Read the quarterly reports (10-Q) and annual reports (10-K) of the stocks you hold to make sure the story remains good. If a company cuts the dividend, or fails to increase it in 1 -2 years without good reason, it may be time to sell.

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Tips
For most companies, low P/E is more important than low P/B. Financial stocks and REITs are major exceptions to this rule, and a price lower than book value is desirable for financial stocks. Don't overpay for quality dividend stocks. Ideally, P/E, P/B, and P/S should all be less than those of the S&P 500. In any case, if P/E exceeds 20, P/B exceeds 6, or P/S exceeds 2, do not buy; instead, set a target price and wait patiently to buy when the stock falls to your target price. Remember, the next bear market is always right around the corner. Reinvest all your dividends. If your broker offers free dividend reinvestment, enroll in it. Stock dilutions are bad, and stock buybacks are good for investment returns. Look at the 10-year financial summary, and look for decreasing or constant number of total shares outstanding. Increased number of shares lowers the earnings per share and dilutes existing

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shareholders' interest in the company. Decreased number of shares increases the earnings per share and increases existing shareholders' interest in the company. Reject stocks with rapidly expanding number of shares outstanding; favor stocks with decreasing number of shares outstanding. Build a diversified portfolio of 15-30 quality dividend stocks. Fewer than 15 stocks, and you may not be adequately diversified against company-specific risks (the Deepwater Horizon oil spill in 2010 for BP is a good example of this). More than 30 stocks is okay, but it might become too cumbersome to monitor all your stock holdings. Consider buying stocks direct via a Direct Stock Purchase (DSP) plan, if you are investing for the long term (15 years or more) and not particular about timing your purchases precisely. It allows you to buy stocks without broker commissions or fees in some cases, allows automatic reinvestment of dividends to build your position, entitles you to receive any shareholder perks offered by the company as a registered shareholder on the company's books (instead of "street name" if you were to buy from a broker), and allows you to dollar-cost average by investing a fixed sum (such as $50) automatically withdrawn from your bank account every month. From the list of quality stocks that fulfill investment criteria, search online or call each company to see if a DSP plan is offered; if so, ask for a prospectus and enrollment form. If the fees are acceptable (lower than you would pay for a broker), and other terms of the plan are satisfactory, enroll in it. Avoid bonds if you are investing for the long term (ten years or more). Bonds are low return investments and their values are corroded by inflation over the long term. The only exception to this rule is when the interest rate exceeds 10% and also exceeds the S&P 500's dividend yield by at least 6%, then you should invest in individual long term bonds to lock in the favorable rates. See Invest in Bonds for full details. If you need income in retirement, equity income from dividends are better than fixed income from bonds, because rising dividends through the years will keep pace with inflation, whereas fixed interest payments from bonds will not.

Warnings
Avoid companies in commodities-based industries, such as Phelps Dodge (copper) and Alcoa (aluminum). Such companies are cyclical, as their earnings are unpredictable and dependent on the price of the commodity. They offer no real long term growth and therefore should have no part in a long term investment portfolio. Don't aim for too high current dividend yields. A 20% dividend yield may be unsustainable and will probably not grow much. On the other hand, don't rely too much on high projected dividend growth that may not materialise. A bird in the hand (current yield) is better than two in the bush (projected dividend growth) in most cases. Dividend cuts are big killers of stock prices. Make sure the companies you invest maintain high quality status (low debt to equity ratio, high interest coverage, increasing revenues and earnings, and high return on equity) and payout ratio does not exceed 60% (except for utilities, REITs, and MLPs, which have high payout ratios).

Things You'll Need

Money to invest for 10 years or more Stock brokerage account or direct stock purchase plans

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Internet access (optional, but helpful)

Related wikiHows
How to Invest in Stocks How to Earn Regular Income from Stock Investing Via Dividends How to Find High Yield Stocks How to Choose Stocks How to Invest in a Bull Market How to Calculate the Dividend Payout Ratio

Sources and Citations

1. http://www.google.com/finance#stockscreener? c0=MarketCap&min0=100000000&c1=DividendYield&min1=3&c2=LTDebtToEquityYear&max2=100& 2. https://personal.vanguard.com/us/FundsAllHoldings? FundId=0920&FundIntExt=INT&tableName=Equity&tableIndex=0&sort=marketValue&sortOrder=desc

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