Finding Safe Stocks with Big Dividend Yields

Shah Gilani|June 26, 2020

If you’ve been searching for yield in the bond market you know there’s not much out there to be had.

Good thing there’s another market where you can find good yielding investments. I’m talking about the stock market.

Hundreds of listed companies pay dividends to their stockholders.

It’s not hard to find lots of big dividend paying stocks in the market, including some really fat yields that look too good to be true.

That’s because some of them are, too good to be true, that is, which means probably too good to last.

Here’s how to tell if a dividend yield is realistic and repeatable.

Then I’m going to tell you why more companies in the future are going to start paying dividends if they don’t already, and why those that are paying shareholders are going to increase their payouts.

And, I’ll tell you how to find good dividend yielding companies and name names for you.

The Basics

There are four simple ratios investors should check out before plunging into any dividend yielding stock.

But, really, there’s only one that you absolutely must know. That’s the dividend payout ratio.

In simple terms, the dividend payout ratio tells you how much a company is taking out of its net profits to pay shareholders their dividend.

It’s important because first of all you’re seeing how much net profit a company is making, then how generous it is with its shareholders, and finally, how much money is left out of net profits to plow back into the business or set aside for the future.

The dividend payout ratio is calculated by taking the total amount of annual dividends paid divided by the company’s annual net income. Or, you can calculate the ratio by taking the annual dividend (in dollars and cents) per share (DPS) and divide that by earnings per share (EPS).

Or you can go to a website like Yahoo Finance and look up the payout ratio on their stock “statistics” page.

Really, it’s that simple.

What to Watch Out For

Generally, a company that pays out less than 50% of its net profits in the form of dividends is considered stable, and shows the company has the potential to raise both its dividend and its earnings over the long term.

A company that pays out greater than 50% may not raise its dividends as much or as often as a company with a lower dividend payout ratio. However, lots of companies with consistent profits do increase their dividends even if their payout ratios are higher than 50%.

Higher payout ratios can always be brought down if the company increases its net profits.

I’m fine with payout ratios as high as 80% if the company has a history of consistent profitability, has enough cash to invest, and has growth potential.

The problem with stocks that have really fat dividend yields, where their dividend payout ratios are high, as in north of 80% to 90%, is they may have trouble maintaining those dividends over the long term.

Some companies have dividend payout ratios greater than 100%. I’ve seen some more than 150%.

If a company’s dividend payout ratio is 100% it’s spending all its net profits paying shareholders and there’s nothing left in the tank to grow the business.

If the payout ratio is more than 100%, the company is borrowing more than it makes to pay its shareholders. That’s dangerous, to say the least, and not a stock you want to invest in.

Not All Payout Ratios are Created Equally

Dividend Coverage Ratio: The Dividend Coverage Ratio, also known as dividend cover, measures the number of times a company can pay dividends to shareholders out of its net income. The coverage ratio is the company’s net income divided by the dividend paid to shareholders. In this case, the higher the ratio, the better. Free Cash Flow to Equity: The FCFE ratio measures the amount of cash that could be paid out to shareholders after all expenses and debts have been paid. FCFE is calculated by subtracting net capital expenditures, debt repayment, and change in net working capital from net income and adding net debt.Investors typically want to see that a company’s dividend payments are paid in full by FCFE. Net Debt to EBITDA Ratio: The net debt to EBITDA (earnings before interest, taxes and depreciation) ratio is calculated by dividing a company’s total liability less cash and cash equivalents by its EBITDA. The net debt to EBITDA ratio measures a company’s leverage and its ability to meet its debt.

When evaluating a company’s dividend payout ratio, investors should only compare a company’s dividend payout ratio with its industry average or similar companies. That’s because different industries operate differently.

Some categories of listed companies, like REITS (Real Estate Investment Trusts), for example, have to payout a minimum amount (90%) of their net taxable income, so you wouldn’t compare the payout ratio on a REIT to the payout ratio an consumer discretionary or pharmaceutical company’s stock.

Besides the all-important dividend payout ratio, investors might want to know what a company’s dividend coverage ratio is, what it’s free cash flow to equity ratio is, and what it’s net debt to EBITDA ratio is.

If a dividend-paying company has a high net debt to EBITDA ratio that has been increasing over multiple periods, the ratio indicates that the company may cut its dividend in the future.

These are all great ratios to use when assessing a company’s ability to pay, maintain, or increase its dividend.

Next time I’ll tell you why companies are going to start paying more dividends to their shareholders.

Then, I’ll tell you how to look for high yielding stocks and name some of my favorites.

Until then,

Shah Gilani