3 Simple Tips to Build a Safe Dividend Income

Do you want a dividend income stream that will increase every year? Here are some simple tips to check for the dividend stocks you’re interested in. The order to check matters because if the dividend stock doesn’t pass checkpoint one, it’s out. 

Don’t slip up. You can keep your dividend income safe by following these 3 simple tips!

Does the dividend stock have a track record of dividend payments?

Notably, this checkpoint allows dividend stocks that have a track record of maintaining or increasing their dividends to pass. Though we prefer stocks to increase their dividends every year, we understand that sometimes the macro environment forces stocks to freeze their dividends. It is a great feat to even maintain dividends during stressful times. 

For example, to be prudent, the regulators forced the big Canadian banks to freeze their dividends around the time of the last financial crisis in 2009 and 2010. Once again, the regulators forced the banks to freeze their dividends. Even the best of the bunch, National Bank of Canada (TSX:NA) has maintained the same quarterly dividend for seven consecutive quarters so far, whereas prior to the pandemic, it increased dividends every two quarters. 

Again, the dividend freeze is no fault of the big banks. National Bank has maintained or increased its dividend every year since at least 2002. Now, that’s a track record!

Depending on your comfortability, you might seek dividend stocks that have maintained or increased dividends for at least five, 10, 15, or 20 years. 

If a dividend stock hasn’t made consistent dividend payments for at least five consecutive years, it’s out. The five-year test would include the stressful pandemic period that we’re experiencing, which is a decent test of resilience/defensiveness for a dividend stock.

Is the dividend stock’s earnings or cash flow stable?

For the big Canadian banks, it makes sense to look at their earnings stability. The graph below provides an easy view of this. The orange line is the adjusted earnings per share. It shows there were only small dips in three years over the long period. Now that’s earnings stability! Stable earnings help contribute to a safe dividend.

Source: F.A.S.T. Graphs. National Bank of Canada stock’s earnings stability.

For real estate investment trusts (REITs) like STORE Capital (NYSE:STOR), instead of earnings, you would look at its funds from operations per share (FFOPS) to help determine its dividend safety.

STOR’s quality shined through when its FFOPS only dropped 8%, and it  continued to increase its dividend last year. 

What’s the dividend stock’s payout ratio?

What’s a safe payout ratio for a dividend stock? It’s different for every industry. Generally, companies with stable earnings or cash flow can afford a higher payout ratio while keeping their dividends safe.

You can compare a dividend stock’s payout ratio against its peers. The big Canadian banks’ payout ratios don’t stray far away from 50% of earnings in a normal environment. Therefore, National Bank’s projected 2021 payout ratio of approximately 36% makes its dividend relatively safe. 

Because of STOR’s stable FFO, its payout ratio tends to be in the 70% range.

Source: F.A.S.T. Graphs. STOR’s dividend and payout ratio history.

Consumer discretionary stocks like Magna International (TSX:MG)(NYSE:MGA) are sensitive to economic cycles. Because of the more unpredictable earnings during down cycles, Magna normally maintains a low payout ratio to aim to protect its dividend that it tends to increase over time. Its payout ratio averaged 20% from 2015-2019, and it jumped to 43% last year because of the pandemic impacts leading to a big drop in adjusted earnings.

Source: F.A.S.T. Graphs. Magna International stock’s earnings volatility and low payout ratio.

One more dividend safety tip

Earn a diversified dividend income stream from a variety of sectors/industries, while keeping the three tips above in mind. This way, if something bad happens to a sector/industry, your other holdings will be fine. 

You might seek safe dividends from these sectors: real estate, utility, financial services, telecom, tech, healthcare, consumer staples, industrials, and consumer discretionary. (I deliberately omitted the basic materials and energy sectors.)

You’ll probably find higher payout ratios in general for REITs, utilities, and telecoms. Low payout ratios but higher growth are likely for tech stocks, as they aim to reinvest a good portion of earnings back into the business for higher growth. 

Investor Summary

Consider dividend stocks that have a track record (+5 years) of dividend payments (preferably, a track record of growing dividends), stable earnings or cash flows, and safe payout ratios. 

If you’re buying stocks with volatile earnings or cash flow, beware that the dividend could be cut if there’s a big drop in earnings or cash flow. 

At the end of the day, your dividend safety comes from individual stock picking. Select quality businesses from a range of industries and sectors to diversify your dividend income stream to spread your risks around.

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  • What’s your process in ensuring your dividend income safety?

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Disclosure: As of writing, we own shares of STOR.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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