With UK inflation picking up on the back of the weaker pound, dividend investors will need to be selective when picking dividend stocks this year. Inflation essentially reduces purchasing power, so in order to avoid going backwards, investors should be looking for companies that can increase their dividend payouts at growth rates at least equal to, but ideally higher than, inflation.
How can investors do that? Here's four things to look for.
It may sound simplistic, but arguably the first thing that investors should look for when analysing dividend growth stocks is revenue growth. Revenue is at the top of the income statement for a reason, and a company's profitability starts with its ability to grow revenue.
If revenue is declining, it's much harder for a company to grow earnings and dividends. So it's wise to examine the company's revenue growth history, and also look at revenue forecasts for the years ahead.
Earnings and cash flow
After revenue, it's also essential to examine earnings and cash flow trends. Investors should look for earnings per share that are rising and that are comfortably in excess of the dividends paid per share. One handy metric in this regard is the dividend coverage ratio, which indicates the capacity of a company to pay its dividend out of the profit attributable to shareholders. The ratio is calculated by dividing net income by the total dividends paid and investors should look for a ratio of at least 1.5 to ensure the dividend isn't at risk.
It's also worth looking at a company's operating cash flow, as when all's said and done, a company requires cash to actually pay a dividend. Investors should look at whether the company's cash flow is increasing and whether it's sufficient to pay the dividend.
Dividend growth history
Another aspect to examine is the company's dividend growth history. Find the company's recent dividend history and calculate the rate of growth year to year. Look for companies that have boosted their dividend payouts consistently at a rate above inflation, 5%-10% per year is ideal. It's also worth examining analyst forecasts for future dividend payouts and this information can be found relatively easily through the internet.
Lastly, it's worth actually looking into the company's dividend policy - the set of guidelines it uses to decide how much of its earnings it will pay out to shareholders. This can usually be found on the company's website or in the annual report. Does the company mention how it increases its dividend? Is dividend growth related to profitability or is it tied to inflation? It's also worth getting a feel for management's commitment to the dividend, and how much emphasis the company places on rewarding shareholders through that dividend.
By paying attention to these issues, investors should be able to make an informed decision about the company's dividend prospects and as a result, invest in companies that have strong payout growth prospects going forward.
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