There's more to picking a great dividend stock than just grabbing the biggest yield available. Sure, dividend yields are important. But there are a number of other factors you need to consider.
For example, you might find a stock paying a great dividend today. But if the company isn't generating the free cash flow necessary to fund its dividend, it might be forced to cut its dividend tomorrow -- in which case you'll be stuck owning a not-so-great dividend stock, and probably one whose stock price is plummeting, as other investors flee the falling dividend.
If falling dividends are bad, then growing dividends are good, right? In that case, you might also want to look into a dividend stock's payout ratio. This metric shows the percentage a company pays in dividends relative to the earnings it uses to pay them. A stock with a 100% payout ratio, for example, may be maxed out and unable to grow its dividend. Conversely, a dividend stock with a payout ratio of only 50% might have ample room to grow its dividend.
And analyst projections for earnings growth provide further confidence that, over time, a stock that pays a good dividend today might pay an even better dividend tomorrow.
With these considerations in mind, I've put together a screen and instructed it to search for companies that are:
- Reasonably large and established, with at least a $2 billion market cap.
- Paying a dividend of at least 3%.
- Devoting less than 70% of annual profits to dividend payouts.
- Generating positive free cash flow.
- Projected to continue earning, and growing their earnings, over the next five years.
What follows are three stocks that appear to fit the bill. Give them a look, and see if you agree.
You may be surprised to find a famous tech stock like Cisco Systems (CSCO -0.57%) leading this list, but the fact is that Cisco pays a terrific dividend. Cisco yields 3.7% as of this writing, far superior to the 2.1% average yield on the S&P 500. At the same time, the payout ratio on this beefy dividend is only 54% of Cisco's profits, which leaves plenty of room for Cisco to pay more dividends later.
As far as valuation goes, Cisco stock sells for less than 16 times trailing earnings -- a bargain in a market where the average stock costs close to 26 times earnings. And Cisco threw off $12.7 billion in positive free cash flow over the past 12 months -- 27% better than its $10 billion in reported net income, according to data from S&P Global Market Intelligence. Even with the slow 5% long-term growth rate that analysts expect Cisco to produce over the next five years, this is a cheap stock with a strong and growable dividend. It's one of the better dividend investments you could make. And considering Cisco has beaten consensus analyst estimates in each of the past four quarters, that "5%" growth prediction could prove conservative.
Another big tech company with an even bigger dividend that's been making analysts look silly lately is International Business Machines (IBM 0.60%). Like Cisco, IBM has exceeded expectations four quarters in a row. Like Cisco, IBM pays a great dividend yield -- actually a bit bigger than Cisco's, at 3.9%.
Granted, IBM is also pegged for slow growth -- 4% annually over the next five years, say the analysts. But with a dividend payout ratio of only 46%, IBM has room to grow its payout with or without fast earnings growth. I also have to wonder whether analysts, in making these conservative estimates, are giving IBM enough credit for the explosive potential of IBM's Watson artificial-intelligence project, which right now seems the most successful such initiative of any of the big AI endeavors.
IBM stock sports a significantly cheaper valuation than Cisco's, with a P/E ratio of only 12.7. It's even cheaper when valued on free cash flow, which is a hefty $12 billion, or about 3% more than reported income. Clearly, investors don't expect to see a lot of growth coming out of IBM stock in the near future. But with a 3.9% dividend yield, dividend-loving investors will be well compensated while they wait for IBM to prove the experts wrong.
Perhaps the most intriguing tech bet for dividend investors, though, is what I consider the best dividend stock in this industry: Qualcomm (QCOM 0.04%). With 70% of its earnings already earmarked for dividends, Qualcomm offers the richest dividend yield on this list, at 4%. But just because Qualcomm has a high payout ratio already doesn't necessarily mean Qualcomm won't be able to increase its dividend in the future.
Qualcomm, you see, is expected to grow its earnings nearly twice as fast as either Cisco or IBM -- 9% annually over the next five years. Plus, Qualcomm generates huge free cash flow to fund its dividends, and to fund further increases -- $5.6 billion in real cash profit generated over the past year, which is 25% better than the net income reported on Qualcomm's income statement.
Does Qualcomm have its issues? Of course it does -- from Apple (and China) challenging the royalties it charges on its products, to slowing sales of mobile phones, to a possible EU objection to its $38 billion acquisition of NXP Semiconductors. Regardless, at just 19 times earnings, and just 15 times free cash flow, a strong growth rate and a generous dividend yield, Qualcomm just might be one of the best dividend stocks out there in the tech industry today.