Dividend Yielding Stocks: Three Keys To Choosing Income-Generating Stocks

| April 27, 2011

I’m at the age now that I talk with my Dad quite a bit.  I find myself enjoying any pearls of wisdom he’s willing to share with me.  It’s quite a change from when I was a defiant teen.  I knew it all back then (or so I thought)…

The last time we spoke, Dad was very concerned about part of his retirement portfolio.  He kept bringing up his CDs specifically.  He feels they’re a waste of time.  They just aren’t generating enough income.

If you own any CDs right now, you know what he’s talking about…

Fortunately, he came to me for help.  I had a solid suggestion I feel is right up his alley.  It’s something he hadn’t considered.  But it’s just what his portfolio needs right now (more on that in a moment).

I have to admit, it feels great to be useful to my Dad.  He’s always been there for me.  And now I can be there for him.

Here’s what I told him…

Move a portion of your stagnant CD money into a handful of high dividend yielding stocks.  Not only do these stocks generate income, they also offer solid growth potential.

Then I followed up my sage advice with a great stock to get the ball rolling.

Now before I tell you which stock we’re starting with, I want to share with you how I chose it.  I’m not randomly picking names out of a hat here…

The first thing I looked at was dividend yield.  I specifically looked for companies with yields between 5% and 10%.  This is the ideal range for dividend yield.

Why?  Well, 5% to 10% is plenty of income to justify the stock’s potential downside risk.

Now don’t get greedy… anything over 10% is too risky.  If a stock is paying over 10%, it could mean there’s something really wrong with the company.  Don’t snap up a risky stock just for a little extra yield.

How do you find these hidden gems?

I use three simple indicators to find the best dividend paying stocks.

First, I look at P/E ratios.  The P/E ratio, to refresh your memory, is a ratio which divides the stock price by the earnings per share.  In other words, it compares the price of a stock to the profits earned by the company.  P/Es are useful for comparing valuations among various stocks.

You see, overvalued stocks typically have very high P/E ratios.  And higher P/E stocks are more likely to tank when the market falls.

But a stock with a low P/E ratio is usually less likely to plunge in an economic downturn.  Clearly, a low P/E ratio stock offers more downside protection in a bad market.

Above all else, a good dividend paying stock must meet one specific requirement…

It must have a level of safety.

Now there are plenty of ways to define “safety”.  But my favorite measure is the debt to equity ratio (D/E).  If a company has more debt than equity (a D/E > 1.0), you need to be very careful.  Too much debt costs money and increases risk.

The key is to compare the company’s D/E to the industry average or other similar companies.  If D/E is in line with these standards, the risk level is acceptable.

It’s important a company’s debt is manageable and prudent.  It means the company is less likely to default on their debt.  And since my father is retired, we wouldn’t want to take on too much risk.  Someday, he’ll need that money.

The last indicator I use helps to protect principal…

Low price volatility.  We want stocks that will rise and fall less than the general market does.  The term for this is beta, and it’s a measureable value.

In this case, we want a low beta stock.  A stock with a beta of 1.0 will rise and fall in line with the markets.  If it’s above 1.0, the stock is more likely to fluctuate more than the market in either direction.  We want stocks with a beta less than 1.0.  These have smaller ups and downs…

Using these indicators, I whittled down the list of companies to just a few quality names.  And one really caught my eye… USA Mobility, Inc. (USMO).

USA Mobility is the result of a merger between the largest paging and network companies in the US.  They specialize in healthcare paging and other network services.  But you probably know them best for their revolutionary push to talk technology.

Over 70% of Fortune 1000 companies use their services.  And USMO provides network services to major 3G and 4G providers such as Sprint and T-Mobile.

Clearly USA Mobility has revenue coming from lots of different customers and channels.  So if they lose a customer or two, they’ll continue generating stable revenue.

Let’s take a closer look at the company’s numbers…

First off, USMO exceeds our 5% threshold for dividend yield.  Their current yield is 6.76%.  This represents a payout equal to 57.3% of earnings.  At 57.3%, they aren’t paying out too much of their earnings, or too little.  A strong indication the yield is sustainable.

Next, USMO is nicely undervalued…

The wireless industry’s average P/E ratio average is 10.4x.  USMO offers even better value, with a P/E of 8.5x.  Clearly USMO has solid upside potential.

   You can see the shares are down from recent highs of $18.77.  But they look to have bottomed around $13 and started moving higher.

Now the best part about USMO…

The company has very little debt.  Their debt to equity ratio is a low 0.16.

Until recently, USMO had no outstanding debt.  But they just acquired Amcom Software for over $162 million.  And the purchase was made with a $52.5 million credit facility from Wells Fargo.

Amazingly, USMO used over $110 million in cash on hand to finance most of the purchase.  And they still have even more cash left on the books after the acquisition…

I think it is fantastic how management is running the company.  They recently announced a stock buyback program that will increase our dividend as time goes on.  As the number of shares outstanding shrinks, the dividend yield will rise.

And finally, USMO has a low beta of 0.89.  Simply said, we won’t see wide swings in USMO’s stock price too often, if at all.

While the stock recently corrected on an earnings report, it has since recovered and can still be purchased at a discount from recent highs.  This looks like a terrific entry point for investors seeking solid growth and income.

USMO satisfies my three criteria for safe, income generating stocks.  My Dad loved the recommendation.  And I’m sure you will too…

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Category: Dividend Stocks

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