How to Choose Dividend Stocks: A 6-Step Health Check for Beginners

Step 1: What exactly is the company paying?

Choosing a dividend stock means judging whether a business can keep paying its owners while it pays all its other bills. The yield on a stock screen is only where your research starts.

Begin with the company's own dividend announcements and payment history. Separate normal dividends from a one-off special dividend. For a fund, check whether a payment is income or a return of capital. A data site can treat one large payment as if it repeats every year, and that makes the yield look too high.

Write down the amount, the currency, the dates and how often it is paid. If the company has announced a change, last year's total may not happen again.

A long record of raises is a good sign about past decisions. The S&P 500 Dividend Aristocrats list, for example, only includes companies that raised their dividend every year for at least 25 years. Even so, a record is not a promise about the next payment.

Step 2: Why can a yield rise when nothing got better?

Let's follow one made-up company, Cedar Parts, through every step. Its shares cost $40 and it pays $1.60 a share each year. Its yield is $1.60 ÷ $40 = 4%.

Now the share price falls to $32, and the dividend stays the same. The yield on your screen becomes $1.60 ÷ $32 = 5%.

The dividend did not go up. The share price fell 20%, and the business may be in worse shape. Find out why the price fell before you treat the higher yield as good news. The same stock can also show different yields on different sites, because each site counts payments its own way.

Free stock screeners on many finance websites can sort thousands of stocks by yield, payout or debt. Our free investing tools guide compares a few. Use them to build a shortlist. Then check each name with the steps below, using the company's own reports.

Step 3: Can profits cover the dividend?

Next, compare the dividend with the company's profit per share, called earnings per share. Cedar earns $4 a share. Its payout ratio is $1.60 ÷ $4 = 40%. It pays out 40% of its profit and keeps the rest.

If profit falls to $2 a share and the dividend stays at $1.60, the payout ratio jumps to 80%. Much less profit is left after the dividend. A ratio above 100% means the company paid out more than it earned that year. Still, no single cut-off number proves that a dividend is safe.

Check whether profit includes a one-off gain or loss. Look at several years, not just one. And take care when profit is tiny or below zero. The ratio can look neat on a screen and still mean very little.

Step 4: Is there enough spare cash?

Profit is an accounting number, but dividends are paid in cash. So check the cash too. In the cash flow statement, find the cash from day-to-day business and the money spent on buildings and machines, called capital spending.

One simple measure of spare cash is free cash flow: cash from the business minus capital spending. Cedar brings in $120 million and spends $50 million, which leaves $70 million. Its dividends cost $56 million in total. That is 80% of its spare cash, a much tighter picture than the 40% profit ratio.

Companies define these numbers in different ways, so always write down what you subtracted. The SEC's beginner's guide to financial statements explains each statement.

Step 5: What else needs the company's cash?

Dividends compete with other bills. Look at when the company's loans are due, how much interest it pays and how much cash it can reach quickly. Debt that must be repaid soon can change the board's choices, even after a long dividend record. Buying back shares and buying other companies also use cash.

Industries differ. A bank is judged on its capital and its loans, not on factory spending like a manufacturer. Do not copy one industry's simple rules to another. If you cannot explain how the company pays for itself, note that gap before you invest.

Picture Cedar with a large loan due next year and cash already tight. The board may have to choose between repaying the loan and keeping the dividend. Loan dates and amounts are listed in the notes to the financial statements.

Step 6: Is the price sensible, and does the stock fit?

A strong company can still disappoint you if its share price already expects too much growth. Compare the price with the company's likely results and with similar companies, allowing for differences in debt and growth. Size matters too: market capitalization tells you what the whole company is valued at.

Then write a short note on what could go wrong. What if sales weaken, costs rise or loans get more expensive? How would that hit the dividend and the share price together? A high yield does not stop a share price from falling.

Finally, decide the most this stock should be in your portfolio, and which risks it shares with what you already own. Keep your sources and their dates. Use SEC EDGAR for US companies and the Canadian disclosure systems for Canadian ones. Our stock research resources list shows where else to look.

Next, compare candidates side by side with the dividend stock worksheet. Then fit your choice into a dividend investing strategy.