What Is a Dividend?

A dividend is a payment made by a company to its shareholders, usually as a distribution of profits. When a corporation earns a profit or surplus, the company can re-invest the profit in the business (called retained earnings) and pay a proportion of the profit as a dividend to shareholders. Distribution to shareholders may be in cash (usually a deposit into a bank account) or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of further shares or share repurchase.

Important Financial Terms Regarding Dividends

Dividend stock ratios are used by analysts and investors to evaluate the dividends a company might pay out in the future. Dividend payouts depend on many factors such as a company’s debt load, its cash flow, and its earnings. The four most popular ratios are the dividend payout ratio, dividend coverage ratio, free cash flow to equity (FCFE), and Net Debt to EBITDA.

1. Dividend Payout Ratio

The dividend payout ratio may be calculated as annual dividends per share (DPS) divided by earnings per share (EPS) or total dividends divided by net income.

Formula:

Payout Ratio = Dividends per Share (DPS) / Earnings per Share (EPS)

2. Dividend Coverage Ratio

The Dividend Coverage Ratio, also called dividend cover, is a financial metric that measures the number of times that a company can pay dividends to its shareholders. The dividend coverage ratio is the ratio of the company’s net income divided by the dividend paid to shareholders.

Formula:

Dividend Coverage Ratio = Net income / Dividend declared

Where:

Net income – is the earnings after all expenses, including taxes, are paid
Dividend declared – is the amount of dividend entitled to shareholders

3. Free Cash Flow to Equity

The Free Cash Flow to Equity (FCFE) ratio measures the amount of cash that could be paid out to shareholders after all expenses and debts have been paid. The 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.

Formula:

FCFE = Cash from Operating Activities – Capital Expenditures + Net Debt Issued (Repaid)

4. Net Debt to EBITDA Ratio

The net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio measures financial leverage and a company’s ability to pay off its debt. Essentially, the net debt to EBITDA ratio (debt/EBITDA) gives an indication as to how long a company would need to operate at its current level to pay off all its debt.

Formula

Net Debt to EBITDA = Debt/EBITDA

Dividend Stocks

Dividend stocks can provide shareholders with foreseeable income as well as long-term growth potential. However, not all dividend stocks are great investments, and a large number of investors aren’t sure how to start their search.

With that in mind, here is a list of dividend-paying stocks you might want to consider.

What to look for in dividend stocks?

If you are new to dividend investing, it’s a smart idea to familiarize yourself with what dividend stocks are and why they can make attractive investments.

Once you have a firm understanding of how dividends work, a few key concepts can help you find excellent dividend stocks for your portfolio.

Payout ratio: A stock’s payout ratio is the amount of money it pays per share in dividends, divided by its earnings per share. In other words, this tells you what percentage of earnings a stock pays to shareholders. A reasonably low payout ratio (say 60% or less) is a good sign that the dividend is sustainable.

History of raises: It’s a very good sign when a company raises its dividend year after year, especially when it can continue to do so during recessions and other tough economic times like the COVID-19 pandemic.

Steady revenue and earnings growth: When looking for the best dividend stocks to own for the long term, prioritize stability in the companies you consider. Unstable revenue (up one year, down the next) and all-over-the-board earnings can be signs of trouble.

Durable competitive advantages: This is perhaps the most important feature to look for. A durable competitive advantage can come in several forms, such as proprietary technology, high customer switching costs, high barriers to entry, or a powerful brand name, just to name a few.

High yield: This is last on the list for a reason. A high yield is obviously preferable to a lower one, but only if the other four criteria are met. A high dividend is only as strong as the business that supports it, so compare dividend yields after you make sure the business is healthy and the payout is stable.

Closing Thoughts

So while the companies listed above should make great long-term dividend investments, don’t worry too much about day-to-day price movements. Instead focus on finding companies with exceptional businesses, stable income streams, and (in preference) strong dividend track records, and the long term will take care of itself.