How to Choose Income Stocks to Invest In
Income stocks are stocks that can provide a steady income by paying a consistent or growing dividend. These companies are usually more mature and generally do not have high growth potential in their businesses.
In this article, I will look at how we can choose income stocks to invest in.
There are at least three metrics to look at before we can decide if a stock will be a good income stock. They are:
1. The Dividend Yield
2. The Dividend Payout Ratio
3. Free Cash Flow
The dividend yield of a stock is simply the dividend per share divided by the share price and multiplied by 100%. For example, if Company A is giving out a dividend of $0.05 per share and its current share price is $2, the dividend yield is 2.5% (($0.05/$2) * 100%).
If a company has a high dividend yield as compared to its peers, it may mean that said company is fundamentally weak; a weak company can have a depressed share price, leading to a high yield. The reverse is also true: A low dividend yield does not mean that a company is “lousy.” It may mean that the company is strong fundamentally, leading to a climbing share price and thus, a low yield.
A good candidate for an income stock would be a fundamentally strong company with a dividend yield that is above the average inflation rate.
Dividend Payout Ratio
This ratio is obtained by taking the dividend per share divided by the earnings per share. The dividend payout ratio tells investors how much of a company’s earnings are paid out yearly as dividends to its shareholders.
Growth companies normally have a low dividend payout ratio as they need to retain capital to grow their business. Mature companies on the other hand, usually have high payout ratios since they can afford to pay out most of their earnings as dividends.
Free Cash Flow
Free cash flow is obtained by deducting a company’s capital expenditure from its cash flow from operations. These figures are in a company’s Cash Flow Statement. Free cash flow is used by a company to pay dividends, buy back shares, repay loans, or re-invest into its business. The more free cash flow a company can generate, the higher the chance it can pay a dividend to shareholders.
Stocks that tick all the boxes above are usually consistent dividend payers. The dividend yield of a company itself tells us nothing about its ability to continue paying good dividends. We have to look at other criteria such as its dividend payout ratio and free cash flow as well.