What I look for to buy dividend stocks

A large part of achieving Financial Independence revolves around earning passive income. The first thought that comes to mind when going about this is investing in dividend stocks. However, not all companies give dividends and not all dividend paying companies would earn a fortune. So lets look into the variables I look for when I look to buy dividend paying stocks.

  • Business Model: Every company has a business model. Essentially a business model is a vision statement that a company abides by. What is important to look for here, is how simple is the business model so that when a not-so smart CEO is in charge of the company, the business would still function smoothly. If I can paraphrase Buffett’s wisdom, “look for companies with a business model you can understand, simple businesses.”
  • Earnings Ability: Most of the companies paying out hefty 3-5% dividends have reached a mature phase of the growth cycle. This means you need to ensure the earnings ability of the business would remain intact for the foreseeable future considering how you aim to make money on this passively.
    • Now, here is the most important caveat, its not the blue-chip companies that have been paying out dividends since ages (example, GE, IBM, etc) that will make you the most money, its the recently turned blue-chip companies like Apple that would give you much more value for your money. Why? Simply because they have recently started to pay out big dividends and would continue to do so for a longer period of time (assuming other things remain constant).
      • Key takeaway: Invest in recently turned blue chip companies, and or companies that have not reached a matured stage of their business cycle and have been increasing dividends.
      • Tip: I frequently visit, the Canadian Dividend All-Star list, in my quest to unearth good dividend paying stocks. Note: not all of the stocks mentioned will fit your criteria, but you would see the reasons for their inclusion, and get a better idea on what metrics to be looking for.
  • Yield: A lot of investors in the FI community focus on yield. To me, this is a double edged sword if this is the sole criterion used. However, use this criteria along with the other two mentioned before, and you get a better picture of the company you are looking at.
    • Yield – Yield is essentially a mathematical formula which tells you the percentage of the cash earned in the form of dividends when compared to the stock price (Yield = Total divs/current stock price). Higher yield is preferred but must be looked in conjunction with other variables.
      • Example – oil stocks in 2014-15, traded at a lucrative yield. If this was the sole criteria, you would have bought a security. However, most of the oil companies slashed their dividends, and their stock prices fell as well due to the bearish business environment in the oil sector. Essentially, higher yields are not sustainable, unless that is the sole way of the company giving our ROE (return on Equity) to their shareholders (like in the case of REITs, income funds, royalty funds).
      • Key takeaway: Look for yield in conjunction with the business model and the earnings ability of the company. You want to be investing in a company  that not only pays out a good dividend, but has a tremendous upside for the stocks price. No wonder, why Buffett has kept his Coca Cola stocks that he bought way back in the 60s-70s.
  • Growth: You want to invest in companies that have been increasing their dividends. A company increasing their dividends is a good sign.
    • Use this variable in conjunction with the earnings ability of the company to get a better understanding of the company.
  • Financial Analysis: After, looking at the first four criteria, I do a quick financial analysis of the company. This enables me to understand the company on a much better level purely by numbers. Words can sometimes paint a rosy picture, but numbers tells you the reality as is. I have explained in my previous posts, on the variables I look for while conducting the financial analysis, click here.

After carefully looking at the variables above, you need to identify a good entry point for the stock. The stock price that you buy plays a huge role in determining the success of your failure. Buy when there is blood on the streets, be greedy when others are fearful.

Recently, I purchased Canadian National Railways and added more to my Apple position due to the late January-early February market correction. The recent purchases agrees with Buffet’s philosophy to buy when others are fearful.

What are some of the variables that you look for when purchasing a dividend paying stock?

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