Owning dividend stocks can be an incredibly lucrative way to invest. In good times, many companies tend to raise their dividends, providing an increasing stream of cash flows to their owners. In not so good times, companies are often reluctant to lower their dividends as long as they can make the payment. That gives its shareholders money to buy even more when prices are low, without having to sell shares to do so.
Still, not every dividend-paying stock is a great investment. If a company can no longer cover its dividend and gets forced to cut it, its share price often falls. That cuts both the income stream and investors' access to cash to invest in better alternatives. To be successful as an income investor, you need to think beyond just the yield. Here are five tips to figure out how to find the best dividend stocks.
No. 1: Look for companies with strong operating moats
For a company to reliably pay a dividend, it needs to be able to generate enough cash to cover its costs, invest in maintaining and expanding its infrastructure, and keeping relevant among its competitors. That's a tall order, and only the strongest companies can sustainably pull it off over the long haul.
Companies that build natural operating moats have an advantage in that as they expand and operate, that very operation and expansion makes it more difficult for competitors to enter their turf. Energy pipeline companies are a great example of companies that build such moats. Their pipelines take a ton of capital to build and often face large community pushback. That combination means that existing pipeline operators have a key advantage over competition trying to enter any given market.
No. 2: Look for companies whose yields are close to others in the industry
If a company's dividend yield is far higher than that of similar companies, it's frequently a sign that it's a "yield trap" -- a company that's about to cut its dividend, and probably see its share price fall along with it. As tempting as it may be to buy a company with a high reported yield for that purported income, recognize the risks that come along with that.
Instead, compare the company's yield to other dividend payers in its industry, or if it's the only dividend payer in its industry you can find, compare it to the overall market's yield. This is a case where being close to everyone else can be a good thing. If its dividend yield looks too good to be true, chances are it probably is, and you'll probably wind up better off moving on to a lower yielding alternative.
No. 3: Look for a "Goldilocks" payout ratio
Similar to the company's overall yield, its payout ratio -- the portion of its income it pays out as its dividend -- can be an important signal of the quality of that dividend. A payout ratio that's too high means the dividend is at risk of being cut because the company can't invest in its operations. A payout ratio that's too low means the company either doesn't really prioritize its dividend or doesn't think its earnings are reliable enough to sustain that dividend over time.
For most companies, that "Goldilocks" zone of not too high, not too low is between around 25% and 75% of earnings. Note that there are a few types of stocks, such as REITs and publicly traded partnerships, where payouts tend to be higher because of the way the underlying businesses are structured. For most other dividend-paying companies, however, those guardrails are worth keeping in mind.
No. 4: Look for solid balance sheets
When times are good, it's easy for a company to pay its dividend. When times are bad, it gets tougher, because dividends are not guaranteed payments. A company's balance sheet reflects all the assets it owns and the liabilities it owes, and those liabilities generally need to get addressed before the company can pay a dividend to its owners.
A company's debt-to-equity ratio is a great balance sheet measure to consider, as it looks at what it owns versus what it owes on those assets. A lower number for that ratio is better than a higher one. Another key measure is its current ratio, which compares what a company owes in the near term vs. what easily available assets it has to pay for those liabilities. A higher number is better for that ratio than a lower one.
No. 5: Look for a trend of rising dividends
A company that increases its dividends both recognizes its shareholders as the owners of the business and directly rewards those owners for the financial risks they take by investing. Increasing a dividend also takes commitment to financial discipline more or less throughout the organization, from the line operations all the way up to the board of directors.
As a result, if a company shows a trend of increasing its dividend, it's a very clear sign that it both respects its owners and that it takes its commitment to its dividend seriously. Particularly when combined with the other four tips, this one can help you find investments that pay you today and pay you even more in the future. And that's something any income investor can appreciate.
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