A dividend portfolio is comprised of stocks of companies that distribute their profits periodically in the form of cash payments.
These cash payments are usually disbursed every quarter as part of these companies’ dividend policy and investors who would like to enjoy receiving a steady stream of income from their investments can build a portfolio comprised of the best dividend stocks by using the eToro platform.
In the following article, we will guide you in the process of building a dividend portfolio from scratch by screening companies based on certain pre-defined criteria.
How do dividends work?
Let’s start this section by defining what a dividend is.
A dividend is an amount of money distributed by a company to its shareholders either in cash or by issuing additional stock.
These dividends typically come from the earnings produced by the business during a given year, although companies can also choose to distribute dividends even if they incur a loss during a given year – in which case they would take the money from their retained earnings pool.
Now that you know what a dividend is, how can you identify which companies are the most suitable to become a part of your dividend portfolio?
In the next section, we will describe a simple method through which you can screen these companies by performing a fundamental analysis of their past financial results.
How to identify the best companies to build a dividend portfolio?
First of all, let’s define the metrics that we will be using to determine which companies we would like to include in our dividend portfolio.
These metrics are:
- Dividend yield.
- Dividend payout ratio.
- Dividend coverage.
- Dividend growth.
- Historical profitability of the business.
- Qualitative assessment of the business.
Meanwhile, here’s a detailed definition for each of these metrics along with potential targets for them that you should look for when picking the companies that will comprise your dividend portfolio.
A stock’s dividend yield can be obtained by dividing its LTM (last twelve months) dividend by the current market price of the shares.
This yield is expressed as a percentage and it indicates how many dollars you will get in the form of dividends for every $100 invested.
Although you might incline to pick the stocks with the highest dividend yields, keep in mind that whenever a stock has an unusually high yield chances are that the market is skeptical about the possibility that such a dividend will continue to be paid as-is in the near future.
On the other hand, it could also be that a temporary downturn may have depressed the market price of the stock, in which case you’ll have to analyze the business in detail to see if such a downtick is justified by a deterioration of the company’s fundamentals or not.
You can check a stock’s dividend yield on eToro by clicking on the “Stats” section of the stock’s individual page. Needless to say, the higher the better as long as the dividend is considered sustainable over time.
Dividend payout ratio
The dividend payout ratio indicates the percentage of a company’s annual profits that are distributed in the form of dividends.
Mature companies tend to offer bigger payout percentages while early-stage businesses that need a lot of capital to keep growing tend to distribute a much lower percentage of their earnings.
A ratio going from 30% to 60% might be considered “healthy” depending on the stage in which the business is in and its capital requirements.
The dividend coverage ratio is obtained by dividing a company’s free cash flow by the amount of dividends to be paid either in the next twelve months or in the last twelve months – depending on the analysts’ preferred approach.
What this indicator tells us is the number of times that the dividend payment is covered by the free cash flow generated by the company during such period, which serves as a good measure of the potential stability of the dividend.
Typically, a ratio above 1.5 can be considered healthy.
One positive sign about the stability of a company’s dividend is that there has been growth in the absolute amount distributed every year.
This would indicate that either the business’ profitability is growing or that the company has expanded its payout ratio lately.
Historical profitability of the business
A business that has maintained a positive track record of earnings growth in the past five years or so should be able to either maintain or grow its dividend payments over time – a positive thing to look for in a prospective dividend stock.
Qualitative assessment of the business
Aside from all the quantitative indicators mentioned above, it is often important to analyze the situation of the industry in which the business is in to make sure that the current dividend will be sustainable in the near future.
We can take the tobacco industry as an example. Although dividends were fairly stable for years, once regulations tightened and consumers started to smoke less due to health concerns, the profitability of big tobacco firms was hurt and, as a result, their dividends were slashed over time.
Is there a way to screen companies that meet these criteria easily?
One possible way to screen companies by using the criteria outlined above is to use a stock screener like FinViz.
Through their website, you can easily filter stocks to short-list potential candidates for your dividend portfolios. After you have done that, you can analyze them individually in case these filters were not as detailed as you would like – that would be a final step in refining your list of prospective dividend stocks.
After you have your final list, you can sign up for eToro to buy these stocks and you can rebalance your portfolio every now and then.
Finally, it would be a good idea to keep an eye on the situation of each of these companies to make sure that they remain in compliance with the criteria you have set forth for your dividend portfolio.
¡Best of luck!