5 Characteristics of Good Dividend Stocks | Learn from Warren Buffett
Warren Buffett earn $4.47 Billion in Dividend Income while doing nothing last year.
What about you?
Warren Buffett is well known for value investing, but do you know he loves to invest in dividend stock as well? In fact, this single dividend stock alone have made him over $560 million in dividends last year.
Yes, if you have guessed, the company is called Coca-Cola (NYSE: KO).
Paying $1.299 billion for 400 million shares for Coca-Cola since 1989. His Coke investment is now worth approx. $20.7 Billion dollars and paying him half a billion dollars in dividends yearly.
So, does Warren Buffett loves dividend stocks? Sure, he does!
Do You Need To Be Smart To Earn Dividends?
Is it even possible for a normal guy, or girl like me to find such a great dividend stock that gives me such amazing returns from dividends?
The short answer is,
“Yes and No.”
What kind of answer is that? Wait, Let me explain.
First, you don’t even need to have an IQ of over 180 or need to be the smartest guy in the world. A normal guy or girl like you can be just as good at investing as some of the pros on wall street.
“Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ.”
Warren Buffett
But for you to be a successful dividend investor, you will need to do something that many investors aren’t willing to do.
Many so-call investors want to be successful, but they are unwilling to learn.
On the other hand.
Smart dividend investor likes you who are willing to learn, will be successful.
How do I know? Simply because you are reading this article!
And that’s what makes you successful and not them.
The old saying, “Knowledge is power” is true.
Here, I will show you the 5 characteristics of good dividend stocks.
These are the characteristics of a good dividend stock that successful investors such as Warren Buffett will look for when investing.
Let’s go!
Characteristics of Good Dividend Stocks
When we are talking about the characteristics of good dividend stocks, we are talking about the fundamentals of a stock, the intrinsic value, and the long-term prospect of a stock. Here are the 5 Characteristics of a Good Dividend Stock:
- Decreasing the Number of Outstanding Shares
- Increasing Earning Per Share (EPS)
- High Return on Equity (ROE)
- Good Dividend Growth History
- Sustainable Dividend Payout Ratio
1. Decreasing the Number of Outstanding Shares
A decreasing number of outstanding shares is great for dividend investors and Warren Buffett totally loves this. It is like the icing on the cake of a great dividend stock. Only good companies will be able to generate lots of cash flow which allows them to have stock buybacks.
These companies usually do a stock buyback when the price of the stocks is below its intrinsic value, or when the company finds the current price of the stock to be attractive.
How does it work?
The decreasing number of outstanding shares by stock buyback is good for investors in 2 ways:
- Stock Buyback makes each share more valuable. Which also gives each shareholder a larger percentage of the business without the investor doing anything.
- Decreasing the number of outstanding shares also helps in increasing the Earning per share (EPS) as there will be fewer shares in the market, making each share become bigger.
Example:
ABC Company has 1,000 outstanding shares and each share is valued at $10.
This means the company is currently priced at $10,000 (1,000 outstanding shares * $10 = $10,000)
You brought 10 shares which have a total value of $100 (10 shares * $10 = $100)
ABC Company had a good year and have lots of cash flow, which they decided to buy back their stocks. They have a stock buyback of 500 shares, which leaves the outstanding shares to decrease to 500
- Original 1,000 outstanding shares, stock buyback of 500 shares, left 500 outstanding shares (1,000 – 500 = 500)
After the stock buyback, you still have 10 shares, but now they are worth $200 instead of the previous $100.
Why?
Even when the number of outstanding shares reduces, the value of the company remains unchanged. Furthermore, the number of shares you hold remains the same, thus each share holds a bigger percentage of the company.
2. Increasing Earning Per Share (EPS)
Increasing Earning Per Share (EPS) shows that the company is doing well. Earning is what allows a company to survive and grow. And with an increase in earnings, shows that the company has some sort of competitive advantage over its competitors.
With a strong brand and business, a company can be differentiated its product to be much more desirable than its competitors. This will allow them to raise their prices, thus increasing their earnings.
A company that is able to have a constant increase in their EPS will be able to afford to pay more dividend to their shareholders.
An example of such a company is the fast food giant which you have been eating since 7 years old.
McDonald’s Corp. has an EPS of just over $2.04 in the year 2005, and today, they have an EPS of $7.62. That is a triple in the EPS in just less than 2 decades. Not too bad for the ‘Big M’.
An increase in the EPS is a good sign of a great company, and by having more cash flow, they can choose to increase the amount of dividend if they want to.
Warren Buffett says to buy a “Wonderful company”.
Increase in EPS is a sign of such wonderful company.
3. High Return on Equity (ROE)
A High Return on Equity (ROE) shows that the company has some sort of moat. ROE is usually used as a measure of the management on how well are they utilizing the money available to them.
A high ROE shows that the management is able to efficiently use the cash flow generated by the business to generate even more returns.
To help in understanding the importance of ROE and for the benefit of those who have no idea of what is ROE. The simple explanation of Equity and ROE is as follows.
What is Equity?
Equity is is the amount left over after liabilities are deducted from assets, or in simple terms, equity is the remaining value of the company if the company sells everything today.
Formula of Equity
- Equity = Asset – Liabilities
What is ROE?
ROE is Return on Equity, it is a metric that is used to measure the quality of management. The number of returns the company generates from the equity of the company.
Formula of ROE
- Net Income/ Equity = Return of Equity (ROE)
What is a good ROE?
A good ROE has these characteristics:
- Higher than average when compared to similar industry
- Stable ROE for 5 to 10 years
- Increasing ROE year after year
After understanding what is equity and ROE, I believe you now have a better understanding of the importance when picking a good dividend stock.
4. Good Dividend Growth History
Good Dividend Growth History shows that the company is doing something right. Although the past result may not assure that it will continue to grow its dividend in the future. It will give you confidence that it will have a higher probability of getting that dividend growth when compared with another company that never grew its dividend.
How to identify a company with good dividend history?
Companies with Good Dividend Growth have these characteristics:
- A business that is resistant to inflation
- Business with a moat (competitive advantage)
- Year-to-year growth in dividends for at least the past 5 years
5. Sustainable Dividend Payout Ratio
A sustainable Dividend Payout Ratio is probably one of the most important characteristics of a good dividend stock. In my opinion, this is the most important amount of all. The reason is simple, dividends are normally taken from the cash flow of the company.
Cash flow is what allows a company to operate. Like the blood in our body, without them, we will not be able to function.
A company that distributes too much of its cash flow as dividend to shareholders might cause the company to fall into crisis.
Without sufficient cash flow, the company may not be able to operate, which forces them to take on more debt than it can manage.
But as dividend investors, we love to see our dividend, but not at the cost of risking the survivability of the company we are investing in.
The word here is:
Balance
Best dividend stocks are able to create a balance between the amount of money they use to reinvest in their business and the amount they distribute to their shareholders. This can be in the form of dividends or share buybacks.
What is a good dividend payout ratio?
A good dividend payout ratio varies between industries and companies.
Dividend payout Ratio is categorized in 5 levels:
- Low: Anything under 15% a low payout ratio
- Average: A range of 15-30% is an average payout ratio
- High: The range of 30-50% is a high payout ratio
- Extremely High: A range of 50-80% is an extremely high payout ratio
- Danger: A range of more than 80% is a danger payout ratio (Exception for certain investments such as REITs)
Generally speaking anything over 80% sounds like a big red “Danger Sign” to almost all of the dividend stocks.
A payout ratio of over 80% means the company is paying almost all, or sometime more than what they are currently earning.
You want to invest long term, not get the dividend today, and let the company close down tomorrow.
Of course, there are some exceptions to certain types of stocks which have a payout ratio of over 80%. They are required to have such a high payout by law, these are called Real Estate Investment Trusts (REITs). You can learn about them in my other articles on the Risk and Benefits of REITs.
My Takeaway
The 5 Characteristics of a Good Dividend Stock allows you to find the stock that can make you millions. You may not be as rich as Warren Buffett who have made Billions from his dividend. But you may able to make some great passive income by buying some great dividend stocks.
5 Characteristics of Good Dividend Stocks:
- Decreasing the Number of Outstanding Shares
- Increasing Earning Per Share (EPS)
- High Return on Equity (ROE)
- Good Dividend Growth History
- Sustainable Dividend Payout Ratio
Finding a good dividend stock might be tough, but it will certainly be worth the effort.
I am currently trying to find a company that meets these 5 characteristics of a good dividend stock. If you have any suggestions probably you may want to write them down in the comments below!
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Each investor have different style in investing and risk appetite.
Dividend investing, growth investing, or even value investing are just some of the different styles of investing. You can use one style or a mix of different styles of investing.
The only way to know which investing style suits you more is to read more.
Warren Buffett read approx 500 pages a day.
Knowledge of investment can be learned from books or articles like this one. Reading can only make you wiser and smarter so that you too may be able to make the right decision in your investment.
“Education is a progressive discovery of our own ignorance.”
Will Durant
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Antony C. is a dividend investor with over 15+ years of investing experience. He’s also the book author of “Start Small, Dream Big“, certified PMP® holder and founder of IncomeBuddies.com (IB). At IB, he share his personal journey and expertise on growing passive income through dividend investing and building online business. Antony has been featured in global news outlet including Yahoo Finance, Nasdaq and Non Fiction Author Association (NFAA).
