What to Consider When Choosing Dividend Paying Stocks

Dividend Growth Investing is a great strategy to build wealth and passive income over a long period of time. I’m a firm advocate that one doesn’t need to be a guru to be a successful investor and that do-it-yourself dividend investing is a solid way to go. Dividend-paying companies as a group, and especially the dividend aristocrats, tend to be mature and stable cash-generating business that provide their shareholders with safe and growing passive income. So, I love seeing people roll up their sleeves and build a dividend portfolio.

Evan from here at My Journey to Millions has given me, Dividend Monk, the opportunity to add my two cents regarding his dividend portfolio. In doing this, I will first post my thoughts regarding his selection criteria, and then I will provide my thoughts regarding his individual dividend selections.

Selection Criteria for Dividend Paying Stocks

Evan listed his criteria clearly,

1. First I listed all the Dividend Aristocrats.
2. Then I cut all those stocks whose P/E ratio was either in line, equal or
worse as compared to the industry standard.
3. Next I looked at yield and
4. Lastly, I looked at Price to Book.

Dividend Aristocrats

The first step, sticking to a list of the dividend aristocrats, was a smart move. There are plenty of great dividend-paying companies outside of this noble list, but for someone who is just starting out in the field of picking individual dividend stocks, limiting the list to the aristocrats keeps the
process safer and more streamlined.

Price to Earnings Ratio

After that, he compared the P/E ratio of the companies to their respective industries. I think this was also quite good. It excludes a number of companies that might make some great investments, but that’s ok. With a low P/E ratio, one wants to be a little bit careful. If the P/E is low, it could be a sign that the company is less valuable than its peers, but on the other hand, it could simply be a good company at an undervalued price.

Dividend Yield

Next, he looked at dividend yield. While one certainly doesn’t want to chase yield alone, as he pointed out early on, one does want to have a significant dividend yield in a portfolio centered around dividends. That’s the whole point, afterall. So everything seems in check here.

Price to Book Ratio

Lastly, Evan looked at the price to book ratio. I can’t say I agree with the way he went about this one. He was given the advice to look for a price to book ratio of close to 1. At one time, this was common practice among value investors, but as times changed and companies have changed, a  price to book ratio close to 1 is not very common in many types of businesses.

Companies that need a lot of assets to produce income (as was common a while back) will have a better chance of having a low price to book ratio. Companies that need few assets to produce earnings, and instead rely on things like service or patents will tend to have higher price to book
ratios. So basically, comparing P/B ratios across the board is comparing apples to oranges.

For some examples, manufacturing and insurance companies will generally have lower price to book values while healthcare and software companies will generally have higher price to book values.  The good news is that including the price to book ratio may have excluded several high-debt companies from his final list.

One wants to be cautious of companies with large amounts of debt. If a company has high debt, its price to book ratio will usually be skewed very high, and if its liabilities exceed assets, its price to book won’t even be computed (as the result will be negative). So by sticking to companies with a low price to book, he increased his chances of attaining companies with clean balance sheets.

If I were to go about it like this, instead of comparing price to book ratios across the board, I would compare price to book ratios on an industry-relative basis like he did with the P/E ratio.

Other Valuations When Building a Dividend Portfolio

There are other critera when considering dividend paying stocks such as long term debt to equity (LT Debt/Equity).  The lower the number, the less leveraged the company is in debt. I prefer to buy low debt companies, since they are better at surviving when economic downturns occur, and have more options available to them when it comes to expanding their business. It also shows management prudence.

Despite missing a few metrics, Evan took into account a few key ratios and values.  Next, I will look into his actual portfolio.

Dividend Monk is a Personal Finance Blogger who believes in the power of dividend paying stocks to create wealth.  Check out his site to read his great stock analysis, or just subscribe to his feed like I do.

9 Responses to What to Consider When Choosing Dividend Paying Stocks

  1. Great tips. I have recently (in the past year or so) been including more dividend paying stocks in my portfolio. Passive income all the way, baby!

  2. Hey Evan, Dividends from Canadian Corporations are taxed preferentially here in Canada (very well, might I add!), but dividends from US corporations is taxed your full marginal tax rate. So if people have dividends from US corporations, its best to keep US dividend paying stocks in registered portfolios.

    How about in the US?

    • Currently, qualified dividends (i.e. US Paying Companies) are taxed at a lower rate, however that is supposed to expire for some, if not all of the population with the end of the Bush Tax Cuts – so we’ll see!

  3. However, as I understand it, the tax rate for dividends will likely only rise to 20% for those of us not in the top tax brackets…is that right? Or is it the rate goes to your income tax rate?

  4. If the US tax cuts are left to expire, as I understand it, dividend income will increase from 15% to the investor’s income tax rate. Congress can extend the cuts, or let them expire, or implement a middle ground where dividend taxation only increases to, say, 20% or another value. I believe that Obama proposed 20%. What the result will be might end up depending on Congress election results.

    I wrote an article about the tax expiration.
    http://dividendmonk.com/dividends-tax-change-2010/

  5. I generally do not pay too much attention to P/E since it is subject to manipulation. I have also found that Dividend Yield in excess of a company’s historical norm to be a precursor of future dividend cuts. I recommend placing more emphasis on valuation metrics (p/s, p/cf, debt/equity, and payout ratio) and then look at the company’s history of dividend increases.

  6. I’ve always been really interested in dividend stocks but for some reason I always thought that stocks with dividends would be out of my price range. Only recently did I realize that dividends are not dependent on stock price but I’m still not holding any dividend paying stocks. I plan to get in on some this year.

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