3 things to check before buying a dividend stock for passive income

Jonathan Smith explains some of the key points he makes sure to tick off before buying any dividend stocks for his portfolio.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

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Buying a dividend stock for passive income can be a great idea. After all, what’s not to like about picking up money as a shareholder when the business pays out some of the profits? However, to ensure that I benefit from a sustainable dividend payout in years to come, there are several things worth checking before making the commitment. 

Starting with the basics

The first thing I look at is the dividend yield. There’s no point me getting excited about a stock if it doesn’t actually pay out a dividend. Even if it does pay one, I need to look to see if it’s good value for money. 

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For example, I might find a stock with a dividend yield of 1%. This might seem a good deal, especially considering that the interest rate from the Bank of England is currently at 0.1%. Yet I need to consider that the average FTSE 100 dividend yield is around 3.4%. So this stock underperforms the average quite considerably. 

This is why it’s important to check the dividend yield before making a call on whether to buy or not. Clearly, I might decide against buying a dividend stock with an above-average yield for valid reasons. I might also choose to buy a low-yielding stock, if I think the potential is there to increase. Either way, it’s a good barometer to start with.

Looking at the history for the future

Another thing I look at with dividend stocks is the history of payments. Some companies have quite erratic dividend payment schedules. For example, I can look at whether the dividend was cut during the pandemic. I can also look back further and see if the dividend was halted over periods in the past decade.

The reason this is important is that I need to consider the future probability of getting paid. If one stock has paid out a dividend every year for the past decade, I think this is a great sign. For others that have missed dividend payments (or have seen big swings in the dividend per share paid out), I’m a bit more cautious.

One point to note here is that the pandemic was a black swan event. So I can still find value in a company that temporarily paused dividend payments, if the rest of its history shows a good track record of payments.

Key metrics for dividend stocks

A final thing I should consider is the balance sheet and income statement. Financial reports are never particularly fun, but they’re important. For example, I’d look at the debt levels of the company. I’d also consider the amount of retained profit the company has, as well as profit margins.

All of these points could impact the dividends that I could receive going forward. Excessive debt could see dividends halted to protect cash flow. Slim profit margins could mean that a good year can flip to a bad year very easily if margins unexpectedly fall.

Overall, I can hopefully give myself the best shot at making good investment choices by taking note of the above points before I buy a dividend stock.

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jonathansmith1 and The Motley Fool UK has no position in any share mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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