What’s not to like about dividends? They are tax efficient, a source of passive cash flow that often grows over time, encourage a buy and hold mentality, and they pay an investor to do nothing! But what exactly is a dividend and how does someone investing know if it can be trusted?

Dividend Basics

A dividend is a payment made to a shareholder of a company. So, if a company pays a 10-cent annual dividend and you own 100 shares, you would receive 10 dollars a year ($0.10*100 shares).

A dividend is paid out of a companies’ earnings and is not considered an expense. So essentially, a dividend is what the company pays out to shareholders after revenues and expenses have been incurred over a period and do not impact the actual profitability of a company.

An important key to remember with dividend stocks is that they are paid at management’s discretion. This means that management could, in theory, cut or eliminate a dividend at any time with no warning. A company is not obligated to pay a dividend.

A dividend yield represents the return the payout offers an investor relative to the share price. If a stock is valued at $5 and pays a 10-cent dividend, the yield on the stock is 2% (0.1/5=2%). This yield will fluctuate as the share price changes. So if the stock price increases, the yield will decrease and vice versa.

Some final basics on dividends relate to the tax efficiency. Since the earnings of a company are taxed, and dividends are paid out of after-tax earnings, investors receive a credit where a dividend is taxed at a lower rate than your income tax rate to avoid double taxation. Easy enough, right? So what are the pros and cons of dividend investing?

Pros to Dividend Investing:

  • Get paid to wait
  • Monthly or quarterly tax-efficient cash flow
  • Dividends tend to grow over time, something the Canadian banks have proved effective at
  • Dividends act as a natural quality filter
  • Reinvesting of dividends can be powerful thanks to compounding returns
  • Keeps management honest, as they can’t make decisions that would jeopardize the dividend

Cons to Dividend Investing:

  • Typically mature, slower growth companies pay a dividend
  • Cash from a dividend can be put to other uses by a company that may generate better returns (growth projects, debt payments, share buybacks, etc.)
  • While tax-efficient, they are still taxed at a higher rate than capital gains
  • No guarantee a dividend is paid indefinitely

High Yield Stocks are often High Risk

Investors often get drawn to stocks with high yields. The idea of getting an annual distribution in the 5%+ range along with the potential of capital gains is very enticing. However, in most cases with high yielding stocks, all that glitters is not gold.

Generally, a high yield is a signal from the market that a dividend is at risk. Since there is no return without risk, it makes sense that the higher the yield on a stock, the higher the risk that is buried in the stock.

A high yield usually means that the share price has recently fallen a material amount (and in turn something bad is happening at the company) or that the market does not think the dividend can be sustained by a company.

Protect Your Dividends by Using the Payout Ratio

Dividend Investing gives you tax efficient source of passive cash flow that grows over time and encourages buy and hold (paying an investor to do nothing).So how does one determine if a distribution is sustainable? The main metric to turn to is the payout ratio. In simple terms, the payout ratio is the annual dividend per share divided by the annual earnings per share. Alternatively, it can be calculated by the total dividends paid over a year divided by the net income over the year. So if net income is $100 and a company pays $10 in dividends, the payout ratio is 10% (10/100=10%). The higher the payout ratio is, the more at risk it is of being cut. A payout in excess of 100% means the company is paying more out in dividends than they make in earnings. This typically can only be sustained for so long through other sources like cash in the company’s bank account.

Like most things in investing, it is not quite so simple though. The above defined payout ratio is a rather crude way to calculate a company’s payout. You can learn more about this ratio and how it should be calculated through this deep dive on the payout ratio calculation.

How to Invest in Dividend Stocks

While there is no silver bullet there are some things an investor can do to stack the deck in their favour:

  • Stick to companies with a dividend yield no higher than 5%
  • Look for companies that grow the dividend over time
  • Focus on payout ratios below 100%
  • Ensure the balance sheet is strong (low debt, some cash). If you don’t wish to do this analysis by yourself, you can view our up-to-date research on some of the top Canadian companies here.
  • See what the dividend history is like
    • Past cuts in the dividend may be a bad sign
    • Consistent and growing dividends are best

Dividend investing can be a rewarding endeavor, and by keeping a few simple rules in mind, an investor can build a stable and reliable source of cash flows over time.

Picking the right dividend stocks yourself can be time-consuming, complicated, and most Canadians don’t want to analyze the financial statements of every company that they’re considering. To help you make an informed decision, you can get the latest research on the top dividend paying companies in Canada for free, by signing up for the free trial at 5i Research (no credit card required). As part of the trial, you’ll also receive instant access to the dividend model portfolio, along with answers to over 57,000 investing questions. You’ll even receive a free question credit to ask the 5i Research Team your top investing/stock question. Sign up for the free instant access here.

About Ryan Modesto

Ryan Modesto is the CEO of 5i Research, an investment research company that provides unbiased research on Canadian stocks and ETFs. Ryan holds the Chartered Financial Analyst designation and is frequently featured on The Globe and Mail, BNN, and Financial Post.? ?Ryan and his team have also answered over 61,100 investing questions from Canadians across the country, through their Q&A service.