3 Easy Tips for Picking a Winning Dividend Stock

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Dividends are essential to successful portfolio construction. When you buy shares in a company that pays a dividend, you are investing in a company whose management is confident in its long-term profitability. However, just because a company pays a dividend doesn’t mean that it is going to be a viable long-term investment. Furthermore, just because a company pays a dividend now doesn’t mean that it is going to pay a dividend in the future.

The fact is that while dividend-paying stocks may seem to be safer, or even better than non-dividend paying stocks, we need to perform due diligence on them all the same. Here are a few tips for picking the winners that will provide you with income for years to come.

1. Know how a company is paying for its dividend

Companies can get the cash to pay dividends from all sorts of sources. Some of these sources indicate that the dividend may not be sustainable or that it is not the product of value creation. There are several companies that have paid dividends by issuing stock or by borrowing money.

For instance one of the most popular dividend paying stocks among income investors is Kinder Morgan Energy Partners LP (NYSE:KMP). If you look at the company’s earnings per share, and then if you look at its dividend payout, you’ll quickly see that in most quarters the company hasn’t made enough money to pay its dividend. For instance in the most recent quarter Kinder Morgan’s EPS came in at $0.67 per share, but it paid $1.38 per share in dividends. The additional money had to come from somewhere. It turns out that the company issued nearly $1 billion worth of debt, and the average number of shares outstanding in the first quarter increased by 8 million versus the prior quarter. This indicates to me that Kinder Morgan’s dividend is not coming from profits. Rather it is coming from capital raises.

On the other hand consider a company such as Microsoft (NASDAQ:MSFT). Microsoft earned $0.78/share in the quarter ended December 31, 2013, but it paid just $0.28/share in dividends. This is a sustainable dividend coming from profits. This is the sort of dividend you should look for when constructing an income portfolio.

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