Three key things to look for when investing in dividend stocks

Dividend stocks can be a great addition to your portfolio, but it’s important to know what to look for when choosing your investment. BlackRock’s Matt Williams provides insight into a fund manager’s thinking.

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A company paying a very high dividend might be appealing from the outside, but it could be a so-called dividend trap – a company that the market believes won’t be able to maintain its dividend because of underlying financial problems.

To avoid a dividend trap, Matt Williams says there are three key things to look for.

The first one is reliability. Dividends are typically cash payments, and to make those payments, companies need to have the cash available. When a company has a weak cash flow, the dividend is among the first of the costs to be cut so be sure to find companies whose operating earnings and cash flow can cover their annual payments at least twice. Although history doesn’t always tell the future, a long history (three to five years or more) of rising dividend payments generally also indicates a stable company.

That ability to increase dividends over time takes us to the second thing to watch for – growth. Williams advises it's best to invest in businesses that have a history of solid growth, whose earnings per share have increased. If a business has maintained a high growth rate for several years, it is likely to continue to do so.  The more a business grows, the more profitable your investment will become. After all, a company that grows dividends without corresponding earnings growth will eventually run out of room to boost distributions.

Finally, no matter how reliable a company is, or how much growth a company has seen, when it comes to investing in a dividend stock, Williams says you also need to be aware of a company’s valuation.

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