Dividend investors and income investors look for reliable dividend payers which have strong business fundamentals. They should be strong generators of cash which deliver popular products or services, healthy margins and limited capital expenditure requirements. Preferably these businesses have sustainable, long term advantages over competitors through unique assets or skills which will help the business produce high levels of profitability for years to come.
Balance sheet strength is critical in ensuring the company doesn’t run into trouble during cyclical downturns, causing it to slash dividends. It can be wise to have some debt but the appropriate amount depends on the reliability of cash flow and earnings and how readily business assets can be liquidated if necessary. As a general guide for a generic industrial company, debt/equity should be under 50% and earnings before interest and tax should cover interest expense by five times or more.
Review the dividend history for dividend reliability. Look back over at least the last five years, preferably longer years or more if the company has been in the same business, to gain an insight into the stability, growth and franking of dividends over an extended period.
Payout ratio (dividend per share divided by earnings per share) should be comfortably under 80% – preferably closer to 70%. This reduces the likelihood of a need to reduce the payout should earnings decline in any one year. Be aware that companies with a 100% or greater payout ratio will be paying out all operating earnings as dividends with little or no funds being reinvested to strengthen and grow the business.
Return on Equity is the profit (before dividends are paid) divided by total shareholders’ equity. It is an annually calculated measure of efficiency and company health. It should be significantly positive, although it will vary by industry.
Observation of these guidelines should support the building of a portfolio of lower risk yield- based investments. Relaxing some of the constraints may provide more investment choices but with added risk.