To know where to find the best dividend stocks, you must first know how to find them. Let me tell you about the criteria I use when searching for a new addition to my Cabot Dividend Investor advisory.
The most important attribute is the most obvious: the dividend. We don’t just love dividends because they generate passive income (although that’s important too). Dividends are actually a sign of company and stock quality as well.
A long history of regular dividend payments is a sign that a company has a predictable business model, high and reliable cash flows and a shareholder-friendly management. Companies that have paid dividends for decades without any cuts score highest on our longevity and consistency rankings (components of my Dividend Safety Rating).
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We also look at a stock’s history of dividend growth. Companies that have increased their dividends by 10% or more for at least 10 years receive high Dividend Growth Scores.
Of course, dividend growth has to come from somewhere, which is why we also want to see earnings and cash flow growth. Earnings growth is the easiest to measure, since public companies report EPS quarterly and analysts make estimates for quarterly and annual EPS numbers. Consistent EPS growth and rising EPS estimates are two of the most important qualities of growth stocks.
But we also look at free cash flow (FCF), which is equal to operating cash flow minus capital expenditures. FCF important because companies pay dividends directly from cash. (If FCF doesn’t cover the dividend, as with new addition Verizon (VZ), the company is getting the cash for dividends from somewhere else, like the balance sheet. This can tide a company over during a cash squeeze, but isn’t sustainable long term.) Companies with strong free cash flow can also invest in growth, make acquisitions and repurchase shares.
Lastly, the payout ratio links the two sides of the story: It compares earnings to dividends, and is a quick way to see what percentage of earnings a company is returning to investors. Traditionally, the payout ratio is the stock’s annual dividend payment divided by its earnings per share (EPS). For example, a company that reports annual EPS of $3.00 per share and makes quarterly dividend payments of 25 cents (for a total yearly dividend of $1) has a payout ratio of 33%. Ratios in the range of 20% to 50% are usually considered sustainable, but the ideal range will vary by industry, company maturity and other factors.
Comparing a company’s current payout ratio to its historical average payout ratio can give you a good idea of whether earnings and dividends are growing at the same rate or if one is outpacing the other. Sometimes, companies will begin to target higher dividend payout ratios as they mature or become more efficient, as Home Depot (HD) announced they would do in January.
We also calculate payout ratios based on FCF for the same reasons we look at FCF. As noted in this month’s recommendation of Verizon, the telecom’s payout ratio based on FCF is currently over 100%, which docks a few points off the stock’s Dividend Safety Rating.
We’ll also consider current yield, valuation metrics, the stock’s technical setup and company- and industry-specific factors, like catalysts for higher earnings and whether the industry is in investors’ good graces. But regardless of the specific situation, our prime selection criteria for the best dividend stocks will always be:
- A long dividend history,
- Consistent dividend growth,
- Earnings and cash flow growth, and
- A sustainable payout ratio.
To learn more about how to find the best dividend stocks, or to simply see which stocks I’m recommending in my Cabot Dividend Investor advisory portfolio, click here to subscribe.
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