There are two main types of dividend stocks:
Companies that grow their dividends consistently every year
Companies that pay a flat dividend every year that makes them yield plays only
My preference has always been to invest in dividend growth companies as opposed to ones that pay a high dividend without the possibility of any growth.
There is a lot of research that clearly shows the tax benefits of the dividend tax credit for investments held in non registered accounts.
In Canada both common and preferred dividends are eligible for the tax credit.
Regardless of the tax benefit, it is still essential to choose your dividend paying securities carefully.
There are many companies that routinely borrow to pay for their dividends.
The cash flow statements of many companies are so difficult to interpret if a company is actually borrowing to pay the dividend.
As an example, many companies use a method of reporting their dividend payout ratios that does not include capital expenditures. By reporting in this manner makes these companies appear more financially sound than they really are.
The most informative payout ratio calculation is as follows:
Common Dividends paid / Operating Cash Flow less capital expenditures and preferred dividends
The denominator is a company’s Free Cash Flow that is what is left over and is frequently used to increase dividends, stock buybacks and make new acquisitions.
Many companies pay a high dividend, yet their Free Cash Flow is negative. This means that they are borrowing to pay for their dividends.
Companies that have a low dividend payout ratio relative to their peers are more likely to increase their dividends.
Plus non-Cash Items- Depreciation, Depletion, Amortization, Deferred Taxes
Less increases in Non-Cash Current Assets
Plus decreases in Non-Cash Current Assets
Less decreases in Current Liabilities
Plus increases in Current Liabilities
Does the company have a levered balance sheet where Long Term Debt is high relative to shareholder’s equity?
Does the company show consistent growth in both operating and free cash flow?
Does the company grow its sales both organically and from acquisitions or only through acquisitions?
Does the company have consistently high Research and Development expenditures that detract from their ability to increase dividends?
Historically companies in cyclical industries like Energy, Materials and Forest Products tend to cut their dividends in an economic recession.
Companies in non cyclical industries like telecom, consumer staples and utilities do not normally cut their dividends in a recession unless there are abnormal circumstances.
Energy infrastructure companies like TC Energy and Enbridge typically do not cut their dividends in a recession as they have limited commodity exposure.
Invest in companies that are financially sound with rising operating and free cash flows in industries that are not cyclical.
Concentrate on companies that have low dividend payout ratios where they have the ability to increase dividends consistently over time.
Do not be tempted to invest in companies with high dividend yields that do not increase their dividends.
Do not forget that banks are cyclical and the dividends of many US companies were cut in the last recession.
Canadian bank dividends have very rarely been cut, but nevertheless all annual growth in their dividends was postponed until after the last recession.
Peter McMurtry, BCom, CFA
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