The Path to Dividends

Dividend-paying stocks have outperformed the market over time. That's a fact -- and it's the reason I write a dividend-oriented newsletter. But so many investors forget this important lesson.

Countless individual investors, burned in the bubble of the late '90s, once again find themselves holding stocks that make promises instead of paying dividends. Folks are welcome to take their chances on newly public (and unprofitable) companies such as Worldspace (Nasdaq: WRSP  ) and Luna Innovations (Nasdaq: LUNA  ) . But why take on all that risk when you can make more money without it?

Getting to know you, getting to know all about you
Dividend stocks are most likely to make real products and provide real services that create real cash flow. They then pay some of this real cash flow out to real shareholders in the form of real dollars. You can then choose to reinvest those real dollars into additional shares of real company stock, or take them down to the grocery store to buy a carton of eggs and make yourself a real omelet, or go on a vacation and get yourself a real sunburn.

Much of that could explain why dividend-paying stocks have performed so well over the long term. But because dividend-paying stocks are often viewed as safer investments, the common perception is that they tend to underperform non-payers in heated markets. While this was true during the Internet-driven craze of the late '90s, it hasn't held true for other periods.

The S&P 500 index jumped from about 100 points in 1980 to just over 1,200 at the end of 2004 -- more than a 1,000% increase. That's a hefty bull market. During that time period, dividend-payers outperformed non-payers by more than 2.6 percentage points per year. While that may not sound like much, if you'd invested $10,000 in dividend-paying stocks in 1980, today you'd have nearly $300,000 -- $120,000 more than your dividend-shunning neighbor.

Getting to hope you like me
So how can you find great dividend stocks yourself? If it were based on yield alone, we'd all be holding nothing but businesses in tough spots like Merck (NYSE: MRK  ) , which is fighting through its Vioxx liability. Of course, there's a place in every portfolio for a company like Merck (which is an Income Investor recommendation), but a high yield isn't always a good yield. Indeed, some of the highest-yielding stocks -- like Merck -- exist because their stocks haven't been going up.

To figure out which substantial dividend payers will also increase in value, we've got to do our homework. The best place to start is cash. After all, that's what we seek as dividend investors: companies that generate extremely large free cash flows (FCF).

Fortunately, there's a lot of cash out there in today's market. U.S. corporate earnings have been on a tear since pulling out of their nosedive a few years ago. As a result, companies have record amounts of cash on their balance sheets, and they're ready to fire it at share buybacks, mergers and acquisitions, and -- you guessed it -- higher dividend payouts.

After you check out the cash situation, make sure your company isn't paying out more than it can handle. The metric for that is the payout ratio, and you want to look for different numbers depending on the class of investment.

For instance, to maintain their tax-advantaged status, real estate investment trusts (REITs) such as Health Care Property Investors (NYSE: HCP  ) are required to pay out 90% of their earnings in the form of dividends, giving them high payout ratios. Growth-oriented stocks like Whole Foods (Nasdaq: WFMI  ) and Yum! Brands (NYSE: YUM  ) tend to pay out less. Those two paid out just 47% and 23%, respectively, during the past full fiscal year.

Then there are the generous dividend-payers in the utility arena, such as American Electric Power (NYSE: AEP  ) , with a payout ratio of 68%.

There's no magic payout ratio appropriate for all companies, but here's the rule of thumb I use to find market-beating investments for subscribers of my Motley Fool Income Investor service:

  • REITs with a funds-from-operations (FFO) payout ratio below 85%.
  • Higher-growth common stocks that pay out less than 50% of FCF.
  • Banks that pay out less than 60% of FCF.
  • Regulated utilities that pay out less than 80% of FCF.

Divining dividends
Of course, there are many other criteria I use to screen the selections that make it into my dividend newsletter, Income Investor -- where the company's cash is coming from (e.g., operations or borrowings), the quality of its management team, a material yield, and a reliable dividend track record. To date, I've used those criteria to identify more than 50 superior stocks, and if you click here for a free one-month guest pass, you'll be able to access today's two newest picks, which were released at 4 p.m. ET.

This article was originally published on Feb. 7, 2005. It has been updated.

In addition to picking winning dividend stocks for Motley Fool Income Investor, Mathew Emmert can whistle half the songs in The King and I, and he can hum the other half. He does not own shares of any company mentioned. Whole Foods is a Stock Advisor recommendation. The Fool has a disclosure policy.


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