4 Key Dividend Ratios to Analyze Dividend Stocks

4 Key Dividend Ratios to Analyze Dividend Stocks

It is no secret that dividend investing is the most reliable form of investing when it comes to building long-term wealth while generating passive income. However, there is a lot more to it than just picking dividend stocks based on high dividend yields. Investors need to have knowledge of the most relevant dividend ratios that explain the company's financial position, the sustainability of the dividend payments, and the future dividend payment potential. 

The purpose of this guide is to explain the 4 most important dividend ratios, their mechanics, and their implementation in dividend stock analysis to formulate winning dividend investing strategies.

Why Analysing Dividend Ratios Matters

Every dividend-paying company provides a reward in the form of a dividend payment every so often. However, not every dividend payment is protected. Some dividend payments are high, but once the dividend is paid, it is not paid again. That is why rational investing and understanding dividend evaluation metrics are so important.

Looking at these ratios gives insight into:

• The ability of a company to continue paying its dividends.

• If there has been an increase in dividends over time.

• If there are sufficient earnings to provide dividends.

• If the dividend-paying stock is priced fairly.

Now, let us examine the 4 primary dividend ratios every investor should use.  

 

 

1. Dividend Yield 

Explanation  

Dividend Yield indicates how much return a shareholder earns from dividends relative to the stock price.  

This ratio is the most liked of all the dividend ratios.  

Formula 

Dividend Yield = (Annual Dividend per Share ÷ Current Share Price) × 100 

Importance 

The ratio helps to:

• Identify if the stock is a high - dividend stock.

• Know how to compare dividend returns from different companies.

• Understand how much income the stock can potentially give.  

Application in Dividing Stock Analysis  

• If the dividend yield is very high (more than 8-10%), it can indicate high risk or falling earnings. 

• It is better to have a moderate yield with stability than a high yield that is unrealistic.  

• The dividend yield is a very good ratio to start with, but like all ratios, it has to be used with the other ratios.

 

2. Dividend Payout Ratio 

Definition

• The dividend payout ratio means how much a company earns and what portion of it is given away as dividends.

• It is a measure of how sustainable the dividend is. 

Formula

Dividend Payout Ratio = (Dividend per Share ÷ Earnings per Share) × 100

Importance of The Dividend Payout Ratio

• Shows if dividends exist from profits.

• Assists in evaluating dividends for the long run.

• Shields you from placing your financial resources into a company whose dividends are out of its financial reach.

Evaluation of the Dividend Payout Ratio for Different Dividend Paying Stocks

Below 50% is a healthy payout ratio.

50% - 70% is a payout ratio for more established and stable firms.

80% - 90% is a risky ratio, but frequent cash flows from a company can mitigate the risk.

When it comes to the dividends out of a company’s profits, this is one of the most important dividend evaluation metrics to determine how safe dividends are. 

 

3. Dividend Cover Ratio

Definition

The dividend cover ratio shows how many times the dividend can get covered by the company’s earnings. It is the opposite of the payout ratio but it gives a better view of the safety of dividends.

Formula

Dividend Cover Ratio = Earnings per Share ÷ Dividend per Share

Why It Matters

• Calculates the profitability of the company.

• Assists in determining companies that will cut dividends in the near future.

• Important in times of recession.

How to Use It

A dividend cover ratio of 2 or above means that dividends are safe.

A ratio lower than 1.5 signifies danger.

A ratio lower than 1 means that the dividend will NOT be paid at all.

This measure is extremely useful for an investor who is looking to develop a solid dividend investment strategy.

 

4. Dividend Growth Rate

Definition

This is the measure of how often a company raises its dividends. Most blue-chip companies are dividend growth companies.

Formula

Dividend Growth Rate = % change in dividend payout year over year

Why It Matters

• Indicates the company will be strong and profitable in the future.

• Helps in identifying a company that will become a high dividend company in the future.

• Demonstrates the confidence that the company has in its management. 

How to Analyse

Most strong businesses are able to grow the dividends once a year and justify an increase of 5-15%. Steady growth is always preferable to erratic spikes in growth or one-off instances.

 

How to Analyze Dividend Stocks

To fully understand how to analyze dividend stocks, you need to understand all four dividend ratios:

Dividend Evaluation Metric	What It Shows
Dividend Yield	Income compared to stock price
Dividend Payout Ratio	Profit portion paid as dividends
Dividend Cover Ratio	Safety and sustainability
Dividend Growth Rate	Long-term dividend potential

 

Using the above ratios summatively gives you a full picture of:

• Stability

• Profitability

• In the long run, their sustainability.

• Income opportunity.

This, below, is the method in which professionals evaluate dividend stocks before including them in their portfolio. 

 

How to start dividend investing.

Here are some rules every dividend investor follows:

 

1. Make Sure of the Advance Continuity of Dividends over the Years

Dependability is nailed in by companies displaying dividends over 5 - 10 year periods.

 

2. Extreme Yields Must Be Avoided

Extremely high yields can suggest danger or sinking stock values.

 

3. Profitable Companies Don’t Exist

Profit is nothing but a reduced flow. It must be in a positive ratio compared to the dividends being paid.

 

4. You Must Benchmark

Relative data can reveal the lacks and the weaknesses of a company or a ratio that it has. 

 

5. Diversify Your Dividend Portfolio

Do not stick to one sector-empower yourself with banks, FMCG, technology, utilities, and manufacturing.

 

 

Conclusion

To properly analyze a stock, one must first understand the four fundamental dividend ratios: dividend yield, dividend payout ratio, dividend cover ratio, and dividend growth rate.  One can create a solid dividend investing strategy and find lucrative, long-lasting companies using these dividend evaluation parameters. Investors can pick sustainable high dividend stocks that provide passive income over many years with the help of these ratios and the analysis of long-term indicators.

 

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.