Dividend stocks can provide a great foundation for an investment portfolio.
But plunking your hard-earned cash into the share with the highest yield could be a costly mistake.
At the moment, nearly a third of stocks listed on the Nairobi Securities Exchange sport dividend yields greater than 4%. But how do you decide which ones stand the best chance of building your wealth over the long-term?
Beware High Debt Loads
After identifying a stock with a high yield, the first thing you want to check is its debt load. Companies that borrow heavily often find it difficult to sustain their dividend when the economy turns sour and interest rates rise.
This is what happened to Kenya Power in 2013. Interest charges on its debt more than doubled when it borrowed to finance extension of the electricity grid, and management was forced to nix its dividend payout.
To minimize this risk, only consider stocks with debt levels lower than 70% of their book value. We calculate this debt to equity ratio by dividing all of the company’s interest-bearing debt by its total equity.
Companies with low debt-to-equity ratios are generally resilient enough to weather tough times without immediately cutting dividend payments to their shareholders.
Don’t Forget Growth
The next thing to look for is the potential for growth. If a company isn’t growing, then it’s unlikely that it will be able to consistently increase its dividend. And if a company isn’t consistently boosting its dividend, you might as well invest in a bond.
Companies often reveal their potential for growth by the percentage of their earnings that they pay out in the form of dividends.
If a company pays out just 10% of its earnings, then it is likely investing the remainder in expansion. Therefore, it stands a good chance of increasing its dividend in the next year. If, however, the company pays out 90% of its earnings, management is essentially saying that it doesn’t have many good ideas about growing the business, so it’s likely that dividend growth will soon stagnate.
So, if a steadily increasing dividend income stream appeals to you, it’s best to avoid companies like Bamburi Cement and Nation Media Group. Both paid out more than 90% of their earnings over the past 12 months. Stick to companies with payout ratios lower than 70% instead.
Consistency is Crucial
If you find a high-yielding company with low debt and a low payout ratio, the final step is to check out its dividend payment history.
You want to avoid companies that slashed their dividend at any time during the past five years. Why? Because if they reduced their dividend one time, there’s a good chance that they’ll be tempted to do it again.
The Dividend Diamond Screen
To recap, screen the market for shares that meet the following standards:
1. Dividend yield > 4%
2. Interest-bearing Debt to Equity Ratio < 0.7
3. Payout Ratio < 70%
4. No dividend cuts in past five years
Kenya’s Top Dividend Stocks
As of September 11, 2016, the following three NSE stocks passed the above screen.
|Yield||LT Debt/Equity||Payout Ratio|
What Do You Think?
Do these results surprise you? Do you have a favorite dividend idea to share? Let’s hear your thoughts in the comments.
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