This article was updated on Jan. 9, 2018, and originally published on June 14, 2017.
Dividend stocks are often considered good defensive plays for frothy markets. But after a nearly nine-year bull run, many dividend stocks now have historically low yields and historically high valuations -- making them risky picks for conservative investors.
Yet investors who ask the right questions can still find solid dividend plays in today's market. Let's take a look at the five main questions you should always ask when looking for sustainable income stocks.
Image source: Getty Images.
1. Do you know the stock's yield?
A stock's yield is found by dividing the dividend paid per share over the past year by the stock's price. That gives you its its trailing yield. Using the dividends that will be paid over the following year gives you its forward yield. The forward yield is generally more reliable, since it accounts for upcoming dividend reductions or hikes.
Income investors generally look for dividend stocks with yields higher than the S&P 500's average yield of 1.9%. For example, AT&T (T 0.22%) and IBM (IBM -0.25%) are both popular dividend plays because they pay respective forward yields of 5.2% and 3.9%.
2. Do you know its payout ratio?
However, you shouldn't simply chase the stocks with the highest yields. This can lead you straight to "high-yield traps" -- or stocks that can't maintain their dividend payments. You can usually spot these traps by checking their payout ratios.
Payout ratio equals the percentage of a company's earnings per share or free cash flow (FCF) that was spent on dividends over the past year. If either of those percentages exceeds 100%, the dividend could be slashed in the near future. Here's how AT&T's and IBM's payout ratios currently look:
| Company |
Earnings Payout Ratio |
FCF Payout Ratio |
|---|---|---|
|
AT&T |
93.2% |
72.7% |
|
IBM |
48.2% |
49.3% |
Data source: Yahoo! Finance.
Those ratios indicate that both companies' dividends are sustainable. They also tell us that IBM, which has a lower yield than AT&T, can afford to pay higher dividends.
3. Are its earnings and FCF rising?
After checking a company's yield and payout ratios, you should check if its earnings and FCF are still growing. For example, analysts expect AT&T and IBM to respectively post 2.5% and 1.5% earnings growth this year.
If we check these companies' earnings reports, we'll notice that AT&T's FCF rose 13% annually to $5.9 billion last quarter, but IBM expects its FCF to stay roughly flat this year. These figures indicate that AT&T has slightly better growth prospects than IBM.
4. Does the company raise its dividend every year?
The best income stocks raise their dividends every year to attract long-term income investors. Companies that pull that off for 25 straight years can join an elite group of stocks known as the Dividend Aristocrats.
AT&T, one of the most well-known Dividend Aristocrats, has raised its dividend annually for over three decades. IBM comes close with 22 straight years of dividend hikes. When a company doesn't raise its dividend every year, it tells us that its earnings growth is in trouble, or it prioritizes other things -- like buybacks or acquisitions -- over dividends.
5. Is it cheap relative to its industry and the overall market?
Low interest rates over the past few years caused many income investors to dump low-yielding bonds for high-yielding blue chip dividend stocks. As a result, many top dividend stocks now trade at high valuations -- meaning that their P/E ratios are higher than the average ratios of their industries or the S&P 500.
For example, dividend stalwart Procter & Gamble (PG 0.33%) currently pays a forward yield of 3%, but it trades at 21 times forward earnings -- indicating that the stock isn't a "cheap" income play at current prices.
When we view AT&T and IBM through the same lens, we'll notice that they're cheaper. AT&T trades at 13 times forward earnings, while IBM has a forward P/E of 12.
Buying dividend stocks can be tricky, and requires more homework than simply choosing the stock with the highest yield. But if you filter your potential investments through these five questions, you should gain a clearer understanding of which qualities define a reliable dividend stock.
