When hunting for dividend stocks to buy, it’s easy to simply screen for or glance at yield and make a pick. But, as with all things related to the stock market, it pays to do a little extra homework.
To better understand why, let’s consider Tesco Corp. (NASDAQ:TESO). The stock boasts a yield of just under 2.1% thanks to a quarterly payout of 5 cents per share — nothing crazy, but also nothing to sneeze at.
Tesco is an easy example for beginner investors because it doesn’t take much digging to see the company is a rocky pick. For starters, some context: The company describes itself as a drilling innovation company and offers technology-based solutions for the upstream energy industry.
And in the last year alone, shares of TESO stock have been sliced by more than 50%.
What’s Wrong With Tesco’s Dividend
That’s the first reason why its 2%-plus dividend yield comes with quite the asterisk. When Tesco Corp. first declared its 5-cent payout in May of 2014, the stock was going for around $20 per share. Take that 20-cent annual payout and divide it by $20 and you get a yield of just 1%.
Today, the yield only looks a bit better because shares look so much worse. A dividend yield is calculated by dividing the annual payout by the stock’s share price. As a stock moves higher, the denominator on that equation gets larger, causing the yield to shrink … and vice versa.
Put another way, the yield has an inverse relationship with stock price. It’s important to make sure a seemingly sweet payout isn’t simply the result of an ugly slide in the stock.
Another quick ratio calculation can help make sure a dividend payout is legitimate — and also proves TESO stock is shaky at best. This ratio is called the “payout ratio” and compares the company’s promised dividend to its posted and projected earnings results. While some companies have lots of cash in the bank to support their dividend, a general guiding rule is that the dividend should be a reasonable percentage of annual earnings, as it increases the chances that investors will continue getting that payment.
While Tesco Corp. boasted 40% earnings growth annually over the last half-decade, earnings are non-existent for the current quarter and current year. And even next year when things get back to the black, Tesco is only expected to post earnings of 12 cents per share.
Once again, the company’s dividend payout is 5 cents per quarter — or 20 cents per share. Even considering the 8% annualized growth analysts expect per year down the pipe, the company will be earning 16 cents per share in 2020 — still not enough to cover the annual payment.
Tack on the fact that Tesco only started paying a dividend early last year — just before things started to go downhill — and it makes one wonder if management made to move in hopes of luring new investors in the wake of a clear downward trend.
Such a strategy could mean even more trouble. The catch-22 of a dividend is that any slight dividend cut is a screaming red flag for investors … and one that can actually multiply losses when investors who were only sticking around for the yield get shaken out and potentially shake out even more owners in the process.
What “Good” Dividend Stocks Look Like
Of course, there’s always some nuance to these metrics. To understand how, let’s consider New York Community Bancorp. (NYSE:NYCB). A back-of-the-napkin payout ratio calculation shows that NYCB’s annual payout of $1 per share is a huge chunk of the $1.05 in earnings it’s slated to post this year — which is a bit high.
But in this case, the company is expected to grow earnings by 10% per year long-term, which will slowly offer more leeway. At 10% growth per year, earnings should have compounded to $2.40 by 2020, which puts the payout ratio below 50%.
On top of that, it’s hardly unreasonable to assume that payout will still be coming steadily that far down the line. NYCB has an impressive track record of paying out 25 cents per quarter; it started in 2004 after a stock split and continued steadily even through the worst of the recession.
In this case, it’s clear management prioritizes that payout for better or for worse … and there’s good reason to assume some “for better” times are on the way. Tesco Corp, on the other hand, started paying its dividend right in the middle of a “for worse” period — which, rather than being a vote of confidence, actually reeks of desperation.
The bottom line: Be sure to do some digging on the best dividend stocks to buy before pulling the trigger. Investors should make sure there are multiple votes of confidence in the form of strong metrics like payout ratio and historical yield. A few quick calculations can help make sure there aren’t red flags hiding behind a nice headline yield.
Alyssa Oursler is based in San Francisco and writes about technology, investing, gender and entrepreneurship. Her work has appeared on Business Insider, MSN Money and more. You can follow her on Twitter here or check out her personal site here. As of this writing, she did not hold a position in any of the aforementioned securities.