Owning stocks that pay dividends can be an incredibly profitable part of your investing strategy, but not every dividend stock is created equal. If you want to find the best dividend stocks, you need to look for ones that have this handful of key characteristics:
- Reasonable payout ratios
- Track records of dividend increases
- Balance sheets that can support the cash payouts even in bad times
- Reasonable market prices compared to their intrinsic values
- Reasons to believe they can continue to reward shareholders with their dividends
Dividend stocks with all those features are few and far between, but if you're really looking for the best of the best, you'll want to pass on the ones that don't make the cut.
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The power of the payout ratio
A company's payout ratio measures how much of the income it earns that it pays out in dividends. In most cases, you're looking for something of a "Goldilocks" level of not too hot and not too cold. Generally speaking, that level is somewhere between 25% and 75% of earnings. On one side, to the extent that dividends enforce discipline by forcing companies to be careful with their cash, a payout much below 25% of earnings may not be sufficient to drive smarter behavior.
On the flip side, a payout ratio that's too high can force a company to cut its dividend in order to protect its balance sheet and ability to continue to operate. When a company cuts its dividend, its share price often falls as well, harming investors from both the loss of income and the loss of principal that reduces their ability to invest elsewhere.
For instance, this August, when Teva Pharmaceutical Industries (TEVA -0.60%) cut its dividend by 75%, its shares dropped from over $30 to less than $20. Teva was forced to cut its dividend as revenues for its blockbuster multiple sclerosis drug Copaxone dropped by 10% and its generics business came under pricing pressure. While the dividend cut should help Teva in the long run by helping it reinvest more in its business, its investors suffered that one-two hit from the reduction in income and share price.
The benefit of a growing dividend
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Over time, inflation eats at the purchasing power of your cash. A company that has the ability to consistently raise its dividend over time can reward you with an increasing income stream to keep up with inflation, without forcing you to sell your shares. Best of all, for that dividend growth to be supported over time, the company needs to be increasing its earnings, thus potentially seeing its share price rise as well.
While it's rare, some companies like healthcare titan Johnson & Johnson (JNJ -1.74%) have been able to increase their dividends annually for over half a century. Whether for the direct income or the signal of strength of the underling business, a growing dividend means more than just the cash in hand for shareholders.
In Johnson & Johnson's case, the rising dividend is a signal that it's in a business (healthcare) that people are willing to spend money on regardless of underlying economic conditions. It's also a signal that within that industry, Johnson & Johnson is able to innovate to continue to grow its revenue and profits in order to keep paying and raising that dividend. For Johnson & Johnson shareholders, it's a direct -- and increasing -- reward for the financial risks they take in owning stock.
Why balance sheets matter
Pipeline giant Kinder Morgan (KMI -1.20%) had a strong track record of increasing its dividends until late 2015. At that point, after Kinder Morgan stepped in to rescue the struggling NGPL pipeline, Moody's threatened a downgrade of Kinder Morgan's debt to junk bond levels due to increased leverage. Kinder Morgan was still generating enough cash to pay its dividend, but the company depended on the debt markets to finance its expansion plans.
That left Kinder Morgan with a tough decision -- scrap its dividend or scrap its expansion plans. In the energy pipeline business, scale matters a great deal, and over the long haul, a rising asset base should translate to a stronger ability to pay more dividends. As a result, Kinder Morgan slashed its dividend by 75% to protect its balance sheet and position itself for stronger long-term growth.
You get what you pay for
Regardless of whether you're an income-oriented investor or one looking for growth, in the end, what matters to you as a shareholder is the total return you receive on your investment. That return is determined by both the dividends you receive and the change in price of the underlying stock during the time you own it.
Over time, a company's cash-generating ability determines its share price performance, even though the market doesn't always reflect the value of that future cash in the short run. For instance, back in July 2014, I sold the shares of J.M. Smucker (SJM 0.30%) I had held in a real-money portfolio managed on Fool.com. I thought at the time, and still think today, that J.M. Smucker is a solid business with great long-term prospects, but I couldn't justify the company's market price compared with its underlying value.
Today, more than three years later, J.M. Smucker's shares trade at around the same level they did back then, despite an approximately 25% rise in the value of the S&P 500 index. Thanks to improvements in its business over time, today's J.M. Smucker looks like a better investment than it did at the same price three years ago.
A reason to believe the dividends can keep growing
Technology titan Apple (AAPL -1.64%) is establishing itself as a solid dividend-growing company, having regularly increased its dividend since initiating the payout in 2012. Combined with a cash-rich balance sheet and a stock price trading below the market's average multiple of earnings, Apple would seem like a superb investment for dividend-oriented investors.
The big risk is that Apple depends on a high-cost, high-tech upgrade cycle to keep new cash coming in. If people decide that last year's model is good enough or otherwise discover that they have a better use for the $1,000 or more it costs to upgrade to the latest gadget, that upgrade cycle can dry up. And that would make it harder for Apple to justify continuing to increase its dividend.
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Put all those factors together to find the best dividend stock
Individually, each of those five factors covers a different aspect of what makes a dividend stock worth owning. Combine them all in your search and you've got a framework to help you find the best dividend stocks around.
