Picking the right dividend stock for my portfolio is the first step to generating some passive income. But this is easier said than done. A common beginner strategy is to simply pick the businesses with the highest dividend yields. Yet this approach will often result in a portfolio containing losing positions that don’t generate any income.
Why? Because high yields are more commonly created by a falling share price rather than an increasing dividend. And in most cases, shares will only drop significantly when there is something fundamentally wrong with the underlying business.
But there are plenty of high-yielding dividend stocks out there that can maintain the impressive payout. So how can I spot the good from the bad? Let’s investigate.
Does the company generate substantial cash flow?
It’s important to remember that stocks pay dividends to shareholders to return excess capital they don’t need. The keyword there is ‘excess’. If a group’s cash flows become compromised, the pool of available capital for dividend payments suddenly starts to dry up.
This is what happened with plenty of travel stocks in early 2020. As countries closed borders to slow the spread of Covid-19, firms such as Carnival saw their revenue streams and, in turn, cash flows, evaporate. With virtually no money coming in, the stock price tanked. And since dividend yield is a function of price, it reached as high as 25%!
The novice investors lured by this seemingly enormous payout are probably quite dissatisfied with their investment. Why? Because within a few weeks, management unsurprisingly announced dividends were being suspended, as the group needed to go into full cash-saving mode to survive the pandemic.
This is something I learned the hard way when I first started investing nearly a decade ago. So when it comes to picking a dividend stock, I always make sure it has the cash flow to back up the payout.
Pick a dividend stock with low debt
Debt can be a powerful financial tool when used correctly. After all, having access to large amounts of capital enables businesses to invest in lucrative opportunities that would otherwise not be possible. However, this does come with a caveat.
Like all loans, the borrower agrees to pay the lender interest, which eats away at the group’s cash flow. When borrowing activity gets too far out of hand, a once-thriving profitable business can quickly find itself in a world of trouble.
Suppose the dividend stock’s operating income is completely gobbled up by interest payments? In that case, there will not be anything left to give to shareholders. In my experience, this is almost always a precursor to a looming dividend cut or outright cancellation. And in some extreme situations, bad management teams will take on additional loans to maintain the stock’s dividend.
Needless to say, this is a recipe for disaster that can often lead to bankruptcy over the long term. That’s why if I spot this sort of activity, I start running for the hills.
