Buying dividend stocks is one of the best ways to generate a passive stream of income from your investment portfolio similar to owning other fixed-income securities such as bonds or income-generating assets such as rental properties.

These stocks provide scheduled payouts whenever issuing companies earn a profit or surplus. Most preferred stocks are dividend-paying stocks while some common stocks may also pay dividends during periods of high profitability.

Guide to Picking the Right Dividend Stocks for Passive Income

One of the major advantages of dividend stocks is that they provide investors with two ways to earn or create wealth: through the regular passive income stream mentioned above and capital appreciation of the stock price in the long haul.

Historical data in the United States have shown that these stocks have outperformed the S&P 500 with less volatility. A number of these dividend-paying stocks are also called defensive stocks or are in defensive sectors that can power through economic downturns.

But picking the right dividend stocks can be challenging. Some have low dividend yields. Those so-called high-yield stocks can come with risks. The following are key pointers and considerations in choosing the best dividend stocks:

1. Understand the Key Metrics for Evaluating Dividend Stocks

You should not invest in stocks based on the recallability or popularity of their issuing companies. Furthermore, when it comes to choosing which dividend stocks to invest in, there are key metrics that can help you in understanding how much dividend to expect and the reliability of the payout. Take note of the following:

• Dividend Yield: The dividend yield or dividend-price ratio is the annualized amount of dividend expressed as a percentage of the stock or share price. For example, if the dividend yield of a company is 3 percent, and its stock price is $150.00, then it pays each of its stockholders $4.50 per share for a given fiscal year. The higher the yield, the higher the income-earning potential of the dividend stock. However, a high dividend yield is not enough to determine the future performance and potential of a dividend stock.

• Dividend Payout Ratio: Another key metric to look for is the dividend payout ratio or the fraction of net income a company pays to its stockholders in dividends. An example would be a company that earns $2.00 per share in net income and pays $1.00 per share in dividends. Its payout ratio is 50 percent. A 30 to 50 percent payout ratio is regarded as sustainable and anything above 50 percent could be unsustainable.

• Earnings Per Share: The earnings per share or EPS can indicate how profitable a company is per share of its stock. Note that the earnings and profitability of a company determine the value of its stock in the stock market and its capabilities to pay dividends to its stockholders and a higher EPS is an indicator that the company has been profitable. Note that a good EPS is above 15 percent.

• Price-to-Earnings Ratio: Calculating and referencing the price-to-earnings or P/E ratio of a company means drawing the relationship between its share price and its earnings per share. A high ratio indicates high earnings expectations from investors while a low ratio can suggest that the company is either undervalued or has been doing exceptionally well based on previous trends. The P/E ratio can be used alongside the dividend yield to determine if a particular dividend stock is properly valued.

The key metrics above can be calculated using data from the financial statements, annual reports, and other official documents of publicly-traded companies. There are also resources and tools available both offline and online that provide readily-accessible financial ratios and other important financial data for quicker financial analysis.

2. Look for Companies with Reasonable Growth in Earnings

Of course, aside from the aforementioned metrics, picking the right dividend stocks should also involve a generalized look at the financial performance of relevant companies. Remember that long-term profitability is an important consideration. Determining this requires ensuring that a particular company has demonstrated consistent growth in terms of earnings and profitability for the past 5 to 10 years or more.

It is also essential to check the track record of this particular company when it comes to paying its stockholders. It should have demonstrated regular and unmissed dividend payouts for at least 5 years, as well as payout growth and yield. In other words, aside from its consistency in releasing dividends, its stock price should have appreciated within the same 5-year period or more, especially under normal economic conditions.

Consider also the industry or sector where a prospective company operates. Look for possible competitors that can undermine its growth potential in the near future. Furthermore, identify factors that can affect its performance such as the current economic condition, the specific market and overall economic outlook, and disruptions from market innovation.

3. Avoid Companies with Excessive and Unsustainable Debts

Debt is normal. One of the ways companies raise capital for expansion is to borrow money from creditors or issue bonds and sell them to individual or institutional investors. However, having an excessive debt can undermine its capabilities to release dividends.

Companies prioritize paying their creditors and bondholders before their preferred stockholders and common stockholders. In other words, instead of committing their earnings to dividend payouts, they tend to channel their funds to pay off their debt obligations until they are able to achieve a healthier cash flow.

The debt-to-equity ratio is the most important metric when it comes to evaluating the level of debt of a particular company, as well as in evaluating its financial leverage and stock. This is calculated by dividing its total liabilities by its shareholder equity. A lower debt-to-equity ratio is preferred because it indicates that a company has less debt on its balance sheet.

However, if the debt-to-equity ratio is too high, it can be indicative of financial distress. The involved company might be having a hard time paying off its debt obligations. A debt-to-equity ratio that is too low is also not a good sign because it indicates that the company is depending too much on shares or stocks to raise capital which is both costly and efficient.

4. Remember that a High Dividend Yield is not Everything

High-yield stocks or dividend stocks with high dividend yields are appealing to inexperienced investors. Note that dividend yield is one of the metrics for evaluating and picking the right dividend stocks. However, yield is not everything. Furthermore, high-yield stocks may have their advantages but they also have notable disadvantages.

One of the disadvantages of high-yield stocks is that although they might be cheap, they could be at high risk of a dividend cut. They could also be overvalued and at risk of a sharp downward trend in their prices.  For example, buying a stock with a 7 percent yield is useless if the company needs to cut its dividend or the stock price itself would fall below 30 percent.

High yield can be a red flag. It can be a byproduct of prices of the underlying stocks falling because of the risk of dividend cuts. It is always important to use other metrics in evaluating dividend stocks, as well as referencing the dividend history of relevant companies.

5. Consider the Features of Each Types of Preferred Stocks

There are different types of preferred stocks. Each has its own unique features and benefits or privileges that should be considered and evaluated when investing in dividend stocks. For example, a prior preferred stock and preference preferred stock have a priority over other preferred stocks when it comes to paying dividends.

Note that there can be instances when a particular company is unable to release dividends to its preferred stockholders. So-called cumulative preferred stocks accumulate unpaid dividends for future payments while non-cumulative preferred stocks do not accumulate unpaid dividends.

A callable preferred stock provides a near-guaranteed dividend payout irrespective of the financial performance of the issuing company. However, uncertainty is a major disadvantage of buying and holding this preferred stock because it can be called or redeemed at the discretion of the issuing company and on a specific date in the future.

Some preferred stocks offer higher payout potential. For example, a participating preferred stock provides investors to with the opportunity to receive extra dividends if the issuing company achieves its financial targets within a particular fiscal year.