Dividends matter a lot. Over the past 10 years, dividend stocks have vastly outperformed non-dividend stocks. In fact, many people have reached early retirement through dividend stocks.
With the market near all time highs, many people are not putting additional money into the market. That’s a fair concern.
After all, if you invested at the top of the market in 2008 or 2000, you would have lost a ton of money for several years!
However, great dividend stocks still pay dividends while you wait for the share price to recover. In fact, great dividend stocks rarely go out of favor. That’s why I’m a big supporter of dividend growth investing.
So, how do you actually select the best dividend stocks to retire on?
Well, here are some criteria you should use in your search!
1. Dividend yield
Dividend yield is always a big concern for dividend investors. After all, the dividend is what sustains our lifestyle!
The dividend yield is a tricky monster. You want a yield that is high…BUT not too high! You want to be in the “Goldilocks” zone.
Typically, I like a stock to yield somewhere between 3% and 7%. Anything higher and the risk of a dividend cut may be too great.
High dividend yields are dangerous because they are not always sustainable. When a dividend darling cuts its dividend, investors bail out HARD! This is because there’s no longer an incentive to hold the stock.
It sucks being caught holding the bag in this circumstance.
We’re not here to gamble on speculative opportunities. We are trying to maintain cash flow in retirement to live comfortably.
Conversely, a lower dividend yield may not be desirable as well. The lower the yield of the portfolio, the bigger it needs to be to cover your expenses.
For example, if you have $50,000 of annual living expenses, then you need a portfolio value of:
*$2.5 million yielding 2.0% to have the $50,000 annual income
*$1.7 million yielding 3.% to have the same $50,000 annual income.
2. Dividend growth and sustainability
It’s not called dividend GROWTH investing for nothing!
Dividend growth is very important because increasing dividend payments will help offset inflation.
Great dividend stocks should be able to raise their dividend payments at a rate that outpaces inflation. As a result, this will preserve your purchasing power.
Similarly, we want to invest in stocks that have a long-term history of dividend sustainability. My minimum is at least 10 years of consecutive dividend payments.
It takes a very financially stable business to pay dividends for 10 straight years.
One very important exercise is to see if any potential interesting dividend stocks cut their dividend in the 2008/2009 recession.
Good dividend companies won’t need to cut their dividend in bad times.
3. Revenue and earnings growth
A big mistake many dividend investors make is investing in very low earnings growth dividend stocks.
I think that’s a bad strategy. Dividend growth is ultimately driven by EARNINGS growth! After all, dividends are paid through increasing profits!
The reality is, many dividend stocks pay high dividends because they don’t have anywhere to invest the money. The business is mature and earnings growth will be in-line with inflation (2% – 3%).
Instead, DGI investors should always target companies that still have a long runway of earnings growth.
Long-term earnings growth of 5%+ is a great target to shoot for.
4. Dividend payout ratio
As I mentioned earlier, dividend sustainability is very important. Never get caught holding a stock that cuts its dividend. It can be very disastrous for your portfolio!
Luckily, there is one very easy metric to calculate the sustainability of dividends. It’s called the dividend payout ratio.
Traditionally, the dividend payout formula is as follows:
Dividend payout ratio = Dividends / Net income
Dividend payout measures how much of profits a company is paying out in dividends. Always be careful of companies that are paying out a significant portion of profits as dividends.
If earnings drop (like during a recession), the dividend may not be safe!
In general, anything about an 80% dividend payout is really high! The only exception is REITs where they are obligated by law to pay out 90% of profits as dividends.
Here is another modified dividend payout ratio I like to use:
Cash dividend payout ratio = Dividends / Free Cash Flow
They say cash is king! Well, sometimes it’s useful to compare dividends paid relative to free cash flow.
Free cash flow is calculated as cash from operations less capital expenditures.
Sometimes we want to use the cash dividend payout ratio because there could be accounting items that impact the normal formula.
For instance, the company could have taken a write-down on an asset or incurred some kind of legal charge. These things don’t really impact cash flow, so they can make the payout ratio seem higher than it is.
Both ratios have their uses and should always be used together.
Valuation is just a way of measuring how cheap or expensive a stock is.
The most common way to value dividend stocks is the price-earnings (P/E) ratio.
Price earnings ratio = Stock price / Earnings-per-share
The P/E ratio measures how much investors are paying for a stock relative to its profits.
For example, a P/E ratio of 20x means investors would be paying 20 bucks for every dollar of profit the business generates!
Check out my valuation post to learn more about valuing dividend stocks!
The great thing about dividend investing is that it’s not too complicated.
The entire strategy can be summarized in one sentence:
Buy stocks that can pay and increase dividend payments over multiple decades!
Hopefully this guide will help you pick dividend stocks for retirement!
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