This is how I pick dividend shares for my passive income portfolio

Like many other Britons, I plan to one day retire with enough passive income to live comfortably into old age. A key part of that plan is making sure I hold the best dividend shares in my portfolio.

Dividend investing is a popular method of earning income from the stock market. It’s particularly effective when done via a Stocks and Shares ISA to reduce tax outgoings.

Please note that tax treatment depends on the individual circumstances of each client and may be subject to change in future. The content in this article is provided for information purposes only. It is not intended to be, neither does it constitute, any form of tax advice. Readers are responsible for carrying out their own due diligence and for obtaining professional advice before making any investment decisions.

I’m still a long way off from achieving my goal, but luckily, I still have many years before retirement. The most important thing is that I have a plan in place — and I’m working each day to make it happen.

Part of that work involves keeping an eye on shifting market trends and rebalancing my dividend portfolio as appropriate.

What makes one stock better than any other?

Dividend shares, for those who don’t know, are shares in companies that pay out regular dividends to shareholders. A dividend is a percentage of an investor’s holdings, paid out either in cash or more shares.

For example, say a company pays out a 1p dividend per share each quarter, equivalent to 4p a year. If the shares cost 100p each, then investors get 4p back on their investment each year. We then say the company has a 4% dividend yield.

Does that mean it’s always best to pick stocks with the highest yields? Oh, if only it were that easy!

Dividend sustainability

The problem with many dividends is that they aren’t exactly reliable. They exist because a company has extra cash to spend — and giving that cash to shareholders is a good way to attract investment.

But when times get tough and profits slip, that cash needs to be spent on more pressing matters. And that’s when dividend cuts happen.

So the most important thing when hunting for dividend stocks is ascertaining their sustainability. To do this, we look at a few key metrics: payment history, payout ratio and dividend coverage.

One example

There’s a host of popular FTSE 100 dividend shares with excellent dividend sustainability metrics, such as BP, National Grid and Rio Tinto. But one lesser-known FTSE 250 dividend stock I’m a particular fan of is challenger bank OSB Group (LSE: OSB).

Its chunky 6.5% dividend yield is supported by a payout ratio of just 48.4%, meaning half its earnings are reinvested into the business. Subsequently, it has ample room to maintain or even raise distributions.

Cash flow comfortably covers dividends 2.39 times, highlighting the quality of earnings behind those payouts. Impressively, it’s delivered 11 consecutive years of uninterrupted dividends, with payments compounding at around 20% annually over the past decade.

Such a record reflects prudent risk management and consistent profitability, even through challenging interest rate cycles. 

Still, there’s a risk that short-term growth may slow slightly in a tougher housing market, limiting further dividend increases. But the combination of high coverage, moderate payout and strong cash generation makes OSB’s dividend sustainability look reassuringly solid and worth considering.

The bottom line

With careful analysis of all relevant factors, it’s possible to pick dividend shares that are likely to deliver long-term passive income.

But no single stock is a winner on its own. A diversified portfolio of 10-20 stocks will help to reduce sector- and regional-specific risks, while enhancing income stability.