5 Signs of a Strong Dividend Stock

After the worst year in more than half a century for dividends, investors need to rethink their strategies for income generation.

Gone are the days when you could buy a dividend-paying stock simply because it's a blue chip and forget about it until retirement. The quick annihilation of dividends at once-reliable companies like Wachovia quickly dispelled that illusion.

For that matter, you'd also be wise to disregard mechanical strategies like dividend-weighted ETFs that might only work under "normal" market conditions.

Instead, it's time to get back to basics.

The keys to success
When researching strong and sustainable dividend-paying stocks for your portfolio, you'll want to focus on those that meet these five criteria.

1. An above-average dividend yield: If you're specifically setting out to find an income-generating stock, make it worth your while. There's no reason to settle for a below-average yield, so use the S&P 500 as a benchmark and screen for stocks with yields above the index's average (currently 1.9%).

2. Sufficient free cash flow cover: It's important that the company generates enough free cash flow (cash from operations minus capital expenditures) to cover its dividend payouts. If the dividend payouts significantly outweigh the free cash flow, the sustainability of the dividend is in question. A reasonable free cash flow payout ratio (dividends paid / free cash flow) should be below 80%.

3. A history of dividend hikes: While a good track record in itself is no guarantee of future payouts, I do like to see a dividend-paying company with a history of rewarding shareholders by increasing its payout in line with earnings growth. Walgreen (NYSE: WAG), for instance, has increased its dividend payout for 35 consecutive years, and Clorox (NYSE: CLX) has done so for 32 years.

4. A solid balance sheet: As we've been reminded over the past 18 months, creditors have a greater claim to a company's earnings and assets than common shareholders. If a company can't repay its creditors, it won't be able to pay you dividends. Look for stocks with interest coverage ratios (EBIT/interest expense) of more than 3.0, but preferably higher. A company with an interest coverage ratio below 1.5 is in danger of being unable to repay its creditors.

5. Undervalued versus the market: You want to buy dividend-paying stocks when they're trading at value prices. Outside of doing a formal discounted cash flow valuation, a good rule of thumb is to look for companies trading at price-to-earnings multiples below the current S&P 500 average (today, it's about 15 times next year's earnings).

There are no hidden tricks or magic formulas here, just reasonable and traditional criteria to help us find strong dividend stocks.

Gimme shelter
Using these five criteria, I screened for stocks trading on a major U.S. exchange with a market cap over $1 billion.

Here are five of the results:

Data courtesy of Capital IQ, a division of Standard & Poor’s, as of Aug. 14, 2009.

While no simple screen ensures a good investment, these are five quality names to research further. Each of them has a strong track record of dividend payouts, plenty of free cash flow to continue paying (and even raising) its dividend, and strong competitive advantages within its industry.

Another thing worth noting is these five are all U.S.-based companies, but it would be unwise to limit your search to domestic stocks -- look globally for dividend ideas. Indeed, around 13% of the results of the screen were based outside the U.S., including TELUS Corporation, a Canadian telecommunications company that yields nearly 6%.

Keep the faith
Now that so many weaker dividend payers have either cut or suspended their payouts, the stronger payers are becoming more apparent. Despite the cuts of the past year, the benefits of owning dividend-paying stocks remain intact.

They:

• Provide you with a real return right away; with non-dividend-paying stocks, returns aren't realized until you sell.
• Allow you to choose what to do with the cash payouts -- reinvest in the stock, put it into savings, or buy groceries. It's up to you.
• Offer you an inflation hedge when companies increase their payouts.

With interest rates so low, stock prices still well below last year's highs, and dividend yields higher than they have been in years, now is a great time to double down on dividends. Using the five criteria outlined above, you'll more easily locate the dividend stocks that can improve your portfolio's income-generating capabilities.

If you're looking for more dividend stock ideas, our Motley Fool Income Investor service can help. Advisor James Early and the Income Investor team recommend both stocks with high yields and those focused more on dividend growth. At present, on average their picks yield 4.7% and have outperformed the S&P by more than five percentage points since the service's inception in 2003.

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This article was originally published on July 9, 2009. It has been updated.

Todd Wenning lives a life of ease and has all he needs -- sky of blue, sea of green, and a yellow submarine. He does not own shares of any company mentioned. Wal-Mart Stores is a Motley Fool Inside Value pick. PepsiCo is a Motley Fool Income Investor pick. The Fool has a disclosure policy.