How I invest in dividend stocks and one pick I’d buy now

As an income investor, I spend a lot of my time looking for the best dividend stocks. My long-term investing aim is to build a portfolio that provides enough passive income from dividends to support my lifestyle.

In this article I want to explain how I invest in dividend stocks and highlight one FTSE 100 share I’d buy today.

One test I use to spot a good dividend

A dividend is a share of a company’s after-tax profits that’s paid to shareholders.

When I’m looking for a good dividend, the first thing I do is compare the dividend payout with the company’s earnings per share.

For example, if a company reports earnings of 50p per share and pays a total dividend of 25p for the year, then the payout is covered twice by earnings. Assuming the company has the cash flow to back up these earnings, then I’d view this as a safe, affordable dividend.

In general, I look for dividend cover of at least 1.5 times earnings. Companies that pay dividends that are greater than earnings are — in my experience — more likely to cut their payouts.

What’s the dividend yield — and will it grow?

The dividend yield is the percentage income provided by a stock from dividend payments. It’s calculated as the annual dividend payment divided by the share price paid.

If I buy a share at 100p that provides a 6p annual dividend, I get a 6% dividend yield.

This brings me to an important lesson I’ve learned. I’ve sometimes been tempted to buy stocks with very high dividend yields. By this, I usually mean more than 6%.

When I’ve bought the shares, the payout has been covered by earnings and looked safe enough. But there’s been a problem.

If a company is paying out too much of its earnings as dividends, then it won’t have much profit left to reinvest in growth. This can lead to a situation where a business stops growing or is forced to borrow money to expand.

When this happens, a dividend cut becomes much more likely, in my experience. Although not all high dividend yields are bad, I think they require careful investigation.

One dividend stock I’d buy now

Packaging group DS Smith (LSE: SMDS) is a £5bn business that specialises in cardboard packaging. It has a big focus on sustainability.

The shares have fallen recently as the company is suffering from high energy prices and raw material costs — just like everyone else. But I think DS Smith is in a good place to generate attractive returns over the next few years.

This stock currently trades on 12 times 2021/22 forecast earnings, with a dividend yield of 3.8%. Broker forecasts suggest that Smith’s earnings and its dividend will both rise by around 15% in 2022/23. If that’s correct, that means buying today could give me a 4.3% yield next year — well above the FTSE 100 average of 3.5%.

DS Smith’s dividend is expected to be covered twice by earnings this year. This would leave plenty of cash spare for investment and debt repayments, reducing the risk of future problems.

I’m thinking about adding more DS Smith shares to my portfolio in the coming weeks. I think it could be a good long-term dividend stock.

Roland Head owns shares of DS Smith. The Motley Fool UK has recommended DS Smith. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.