Dividend stocks are a popular way to earn passive income on the stock market. The regular payments made to shareholders can equate to a decent flow of cash.
When investing in dividend shares, early investors often fall foul of some common mistakes.
Here are two to keep in mind.
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Not all companies are created equal
There’s no shortcut when picking dividend stocks and no single model that applies to all companies. When considering investing for dividends, the individual strengths and weaknesses of reach company must be accounted for.
This is particularly true when it comes to dividend coverage. This metric is used to assess how much cash the company has to cover its dividend obligations. Presumably, if its cash is less than the full amount of dividends, there’s going to be a problem.
Companies that need steady cash flow to operate typically pay a low dividend and as such, have high coverage. However, some companies don’t need much cash to operate and so pay a high dividend with low coverage. This reveals how low coverage isn’t necessarily a bad thing.
It’s important to find out how the company operates before making a decision based solely on coverage. Even a company with high coverage may cut the dividend if it has a lot of debt to finance.
These factors differ from company to company, so each one needs to be assessed on an individual basis.
Investing for the yield
Investing purely for the yield isn’t a good long-term strategy. Yields fluctuate wildly and are often high for the wrong reasons, such as a crashing price.
Some investors buy stocks just before the ex-dividend date as a way to lock in a yield at a certain level. This can be a smart strategy but doesn’t guarantee anything. Ignoring the company’s fundamentals and potential price movements is risky. If the stock falls more than the yield before payment, then it’s all for nothing.
Before making a decision based on the yield, investors should always carefully assess the company’s financial position.
Examples to consider
In 2023, Vodafone had one of the highest yields on the FTSE 100, at 10.8%. But falling earnings forced it to slash the dividend in half, bringing the new yield closer to 5%. Investors who bought for the yield and didn’t foresee the problems would have been disappointed.
Fellow telecoms giant BT Group currently has a yield of 5.7% and sufficient cash to cover dividends. However, it’s drowning in £18.9bn of debt, ramping up the possibility of a dividend cut in the near future.
The specialist staffing company SThree (LSE: STEM) looks more promising and may be worth considering. It has a 5.8% yield that’s well-covered by cash flows. Additionally, its cash has almost doubled since 2021 while its debt has decreased. Annual dividends have also increased from 11p to 16.9p per share.
But a challenging job market led to a profit warning last month that spooked investors. An expected 61% decline in pre-tax profit caused the stock to crash. Now with a price-to-earnings (P/E) ratio of only 6, it looks attractive. But if the market doesn’t recover, it could still fall further.
Still, I like its long-term prospects. Revenue has been climbing for several years and analysts forecast on average a 30% price increase in the next 12 months.
