A higher dividend yield is not always better: What an investor should look for when selecting a quality dividend stock

When it comes to dividends, there are a few things to watch out for. Many investors naturally gravitate towards stocks with the highest dividend yields. However, they should resist this urge. This article highlights the main factors investors should look for when searching for a quality dividend stock.

Dividend investing is a proven method of wealth accumulation that offers protection against inflation.

Choose quality over quantity

One of the most important considerations for investors when choosing an investment is dividend yield. A higher yield is not always better and can be deceiving. If current stock payout levels are not sustainable over the long term, those dividends can be cut quickly.

Choosing an investment that offers more stability may mean sacrificing some level of yield in the short term, but the outcome may be more favorable, especially for long-term investors. The income generated by lower-risk dividend stocks may be lower, but is likely to be more reliable over time.

Strong profitability, growth expectations

One of the other key considerations when screening dividend-paying companies is long-term profitability. In addition to looking at past and current earnings, it's also important to look at a company's future potential to increase its dividend payout.

Additionally, investors should look for companies with the healthy cash flow generation (Cash Flow) needed to pay these dividends.

Stick with companies with a long history

Finally, a minimum five-year history of strong dividend payouts signals continued dividend growth. When selecting dividend investments, there is no better benchmark than a stock's past performance.

One strategy may also be to select only companies that have earned "dividend aristocrat" status. These are established companies that have consistently increased their dividend payouts to investors over the previous 25 years. Their brands are easily recognizable and generate a steady stream of cash flow with a high probability of continuing to do so in the future.

Remember the payout ratio

A company's dividend payout ratio can reveal how safe an investment is. This ratio tells investors not only how much is being paid to shareholders, but also how much income the company can keep.

If you come across a dividend stock with a high yield, but the company pays out a significant percentage of its income to investors, it's a sign that you need to proceed with caution. If the company sees a reduction in its income stream, the dividend amount could fall.

Avoid debt

Investors should avoid dividend-paying companies that are in debt. Simply put: companies with debt tend to direct their funds to repay it rather than devote that capital to their dividend payout programs. For this reason, it is essential that investors examine a company's debt-to-equity ratio (Debt/Eq). This should ideally be no higher than 2. However, there are several indicators of the level of debt.

Bottom line

If you plan to invest in dividend stocks, focus on companies whose dividends are most likely to grow. This growth should be supported by strong cash flows, a low debt-to-equity ratio and industrial strength.

DISCLAIMER: All information herein is for informational purposes only and is in no way an investment recommendation. Always do your own analysis.