How can we identify good dividend paying stocks for passive income?

Not all stocks which pay a high dividend are considered good & fundamentally strong to support your retirement. Picking an equity share for a steady source of passive income highly depends on the future sustainability of the company & the environment in which it operates.

What is the Right Approach with Dividend?

A good dividend stock is highly dependent on the following two conditions

  • Consistent dividend payout
  • Consistent Growth in dividend payout

But for me, the best approach to select a dividend stock is “Grow Profitability” dividend will maximise. So invest in the right stock at the right price, and as the share price appreciates, the dividend amount will look handsome.

Let me give you some example of India’s two Return maximising companies which has not only created wealth by appreciation but also provided regular income in the form of growing dividend. (Not Recommendation)

TCS & HUL, They not only pay high dividends regularly but also grow with inflation as shown below in the chart. (TCS on the Left axis & HUL on the Right axis)


Another example which is even in my portfolio of investment, Pidilite Industries. (Not Recommendation)

As on current share price of 25th August 2020, Dividend yield provided by Pidilite industries is 0.47% only. But as per my investment price of ₹1297 (7th April 2020), it will be 0.54%. As shown in the table below dividend payout has also increased constantly along with the share price of Pidilite from ₹566 to ₹1400+ in almost 5 years.

Year Dividend Payout
2020 ₹7.00 +
2019 ₹6.50
2018 ₹6.00
2017 ₹4.75
2016 ₹4.15

As the Earning per Share (EPS) of the share increases, they will share more dividend. An investor must understand dividend yield may or may not increase due to appreciation in base share price, but in absolute terms dividend will increase over time. So as I said, “Grow Profitability, Dividend will maximise”.

So do all companies promises to pay growing dividends? No.

Hence it is important to identify fundamentally strong companies with promising cash flow in the future. Is identifying such companies easy? No.

How Do I get one? By Studying Financial Reports

This is the hint which will help you to find the right stock with the potential to pay high dividends.

Dividend payout is a process used by the companies to share the profit with its investors & a good company with a promising future always tries to increase the cash flow towards its shareholder in the form of dividends.

We all know now what is a dividend? It is a part of companies profit or earnings. Which directly means a company earns more, pays more. If a company makes more net profits, will pay higher dividends.

Do the following:

  • Select Debt-free companies
  • 1st check for Operating profits & Per-share earnings are growing in the last 3 to 5 Years
  • Check the growth rate of Earnings Per Share per financial year
  • 2nd check for dividend payout by the company is growing or not
  • Check the growth rate of Dividend paid per financial year

A company is said fundamentally strong when its income from operations increases year on year, but when a net profit improving company pay a dividend at the same growth rate it is said to be a good dividend-paying company.

Remember:

  • Always compare the per-share earnings growth rate and dividend per share growth rate, they should be similar
  • The company should believe in dividend philosophy
  • The share price of dividend-paying companies are relatively stable, providing stability in the portfolio & act as a hedge against market collapses

All coins have two sides:

Limitation of Dividend based investing

An investor must be always aware of the limitations of an investment strategy before applying for it, it helps in enjoying the benefits & also in taking precautions.

  • Dividend yields are not reliable: One should never invest in a stock just based on dividend yield. A stock paying a high dividend in the current year, may not pay any dividend in coming 3 to 4 years
  • Dividend is high, Fundamental Weak: Initial value of the investment can become Zero. If the earning of a company keeps on declining, it will result in a fall in share price, generating negative returns. People who bought such stock then, for dividend yield, must be feeling disappointed today
    • For Instance: Tata Motors

Point to keep in mind:

It is important to look & consider dividend yield, but an investor should make sure yields are supported by a strong sales book, high margins & growth.

Conclusion:

Reinvestment is the MANTRA for successful dividend based investing. Reinvest the dividend earned in the initial years which may further increase the yield & provide averaging benefits.

“Use dividend income, to BUY more dividend-paying stocks”

Follow the strategy for 15 to 20 years, you will surely create wealth for generations. Warren Buffett earns billions in dividend alone, set your monthly dividend target today.