How to Find Great Dividend Bargains

Source: Flickr user Paul§.

Even after the recent rebound, the U.S. stock market is still well below its highs, and there are still some good bargains to be found for dividend investors with a long-term mentality. However, not all dividend stocks are good investments just because they're trading at lower prices. Here's a quick guide to finding dividend bargains that you can apply to your own portfolio.

Scenarios that produce cheap stocks
There are several reasons stocks can drop, creating bargains for savvy investors. For starters, in a market correction or recession, most stocks will go down, even though their underlying businesses are fine. In fact, the market is currently down 6% from its high as I write this, and many stocks are just as fundamentally healthy as ever.

If one company in a sector reports bad news, it can adversely affect the entire sector. This happens frequently, especially in the retail sector. As a hypothetical example, if Coach reports that it's having a bad holiday season, the stocks of similar companies like Michael Kors are likely to drop, as well, whether or not their sales are affected.

Finally, if an entire industry is having tough times, it could be a good time to find cheap stocks to hold for the long term. An obvious example right now is in the energy sector, and several billionaire investors have been buying up sector-leading companies cheaply.

A word of caution
Just because a dividend stock is cheap doesn't automatically make it a good investment. If a stock is down for company-specific reasons, it should generally be avoided. Good reasons to avoid "cheap" dividend stocks include:

• Sales have declined recently
• Debt has gotten higher or has become unsustainable
• Cash flow has declined, or has even gone negative
• The company is under investigation for wrongdoing

What to look for
Once you've identified stocks that appear cheap for reasons that aren't company specific, it's time to do a little more digging. For starters, you'll want to ask the following questions:

1. Does the company have a strong history of increasing its dividend?
   There are many companies that have increased their dividends for decades, but it's not a requirement. You simply want to verify that the company makes an effort to increase shareholders' income over time, and doesn't have a history of dividend cuts or suspended payments.
2. Does the company have a reasonable payout ratio that will sustain the dividend?
   A payout ratio tells you how much of the company's income is paid out as dividends, and the lower this number is, the easier the dividend is to sustain. For example, if a company earns $3.00 per share and pays a dividend of $1.00, its payout ratio is 33% -- which leaves plenty of room for increases, as well as a nice cushion if income suffers during a recession.
3. Is the company's debt load reasonable and manageable -- even if times get tough?
   A "reasonable" debt load is open to interpretation, and some companies can responsibly borrow more than others. A good metric to look at is the company's interest coverage, which tells you how much the company earns for every dollar in interest expenses. For example, if a company's interest coverage is five-to-one, it can absorb a huge drop in revenue before paying its debt becomes a problem.
4. Is the company's income steady and (reasonably) predictable?
   While it's impossible to accurately project a company's future income, there should be a steady pattern of earnings growth, as well as absorbing tough times without much of an earnings drop. As an example, take a look at the sales of two retailers, Wal-Mart (WMT 0.39%) and Abercrombie & Fitch (ANF -0.30%) during the 2007-2012 period.

 
As you can see, Wal-Mart has a much steadier income stream that tends to increase slowly but surely -- even when the market gets rough. Stocks like Abercrombie can make good speculative growth plays, but their ups and downs aren't suitable for long-term investing.

5. Does the company have a wide moat?
Essentially, a wide moat refers to a sustainable advantage that should make the company an excellent investment for the foreseeable future. For example, Coca-Cola's wide moat is its valuable brand name and widespread operation. Wal-Mart's is its size, which allows it to sell goods more cheaply than competitors.

If you can answer "yes" to all of these questions, the company could be a good dividend stock to buy and hold for the long term, even though its price has fallen.

An example
To illustrate these rules, let's consider one of my favorite dividend-paying bargains in the market right now, ExxonMobil (XOM 0.21%). ExxonMobil is down primarily due to sector weakness, and the overall market drop isn't helping either. Still, the company's business is sound, and there's no reason to doubt Exxon's merit as a long-term investment.

Here's how the rules I listed above apply to Exxon:

1. ExxonMobil has increased its dividend for 32 consecutive years, a time period that includes several plunges in oil prices.
2. The company pays $2.92 in annual dividends, and is expected to earn $4.10 in 2015. While the 71% payout ratio is on the high side, another way to interpret this is that Exxon earns more than enough to cover its dividend even in an oil market that's considered a "worst-case scenario" by many experts.
3. ExxonMobil has about $34 billion in total debt, which is rather small considering its market capitalization of more than $312 billion. Plus, the company is one of only three with a top-notch AAA credit rating, meaning that it pays less interest on its debt than virtually all of its peers.
4. Obviously, ExxonMobil's revenue is dependent on oil prices, which aren't strong right now. However, when you consider that the company's quarterly revenue has dropped by 31% during the past four quarters despite a drop of 51% in oil prices, it shows that Exxon fares well during the tough times.
5. Exxon's wide moat is its size, the diversification of its operations (some of Exxon's businesses actually do better when oil prices fall), and its stellar credit rating.

Other dividend stocks currently "on sale"
ExxonMobil is just one example -- there are hundreds of dividend stocks that could be excellent buys right now. The point here is to get you to be smart about bargain hunting by first finding stocks that have dropped in price for reasons not specific to their own businesses, and then to do a little research to figure out whether or not they are good long-term investment candidates.

There are plenty of bargains out there -- you just need to do your homework to separate the stocks that are cheap for a reason from the true opportunities.