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Here's How to Find the Best Dividend Stocks

By Matthew DiLallo – Sep 30, 2018 at 3:39AM

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The top dividend stocks all seem to have these three factors.

Dividends have proven to be powerful tools for creating wealth over the years. Companies in the S&P 500 that pay a dividend have generated a 9.25% total annual return, according to Ned Davis Research using data that goes all the way back to 1972. For comparison's sake, non-payers only produced a 2.61% annual return, which pulled the weighted average of the S&P 500 down to 7.7%.

However, while just paying a dividend increased the probability that a company's stock would outperform, not all dividend payers did. Those that didn't raise their payouts only generated a 7.47% total annual return, while those that cut or eliminated them produced a negative 0.35% return. The best dividend stocks, on the other hand, were those that initiated or increased their dividends as they delivered a 10.07% total annual return. Here are three things the best dividend-growth stocks tend to have in common.

$100 bills sitting under a paper with the word "Dividends" on it.

Image source: Getty Images.

1. They generate gobs of steady cash flow

The foundation of any dividend is a company's free cash flow, which is the money it has left over after paying all its bills and investing to drive future growth. Because of that, dividend-paying companies tend to be highly profitable and operate in more mature industries, which enables them to generate enough excess cash to meet their business needs and pay a dividend.

However, what separates the best dividend stocks from the pack is the underlying stability of their cash flows. One common factor that helps a company generate steady cash is that they have a business model that produces relatively recurring sales. That happens by selling the same (or similar) thing(s) to the same customers over and over again. Think utilities, cable companies, or those that sell consumer staples like adhesive bandages and paper towels.

One industry known for producing stable cash flow is the pipeline sector. That's evident by taking a closer look at one of the largest operators in that space, Enterprise Products Partners (EPD 0.12%), which has generated between $1.93 to $2.06 per unit of free cash flow over the last five years.

What's impressive about the stability of Enterprise Products Partners' cash flow over that time frame is that it came during a period when crude prices crashed. That downturn had a minimal impact on Enterprise's cash flow because it secured long-term, free-based contracts to lock in volumes on its systems, which allows it to produce predictable cash flow in both good times and bad.

2. They have a conservative financial profile

A second common factor found in the best dividend stocks is that they have a sturdy financial foundation. One aspect is that they have a strong balance sheet with a low level of debt compared to others in their sector and an investment-grade credit rating. The reason having a high credit rating is important is that it signifies that a company should be able to meet its financial obligations during challenging economic conditions, making it less likely that it would need to cut or eliminate its dividend. Further, an investment-grade credit rating reduces a company's borrowing rate while making it easier to access credit.

Meanwhile, a second important financial characteristic found in the best dividend stocks is a low payout ratio, which is the percentage of profits paid out to support the dividend. While the ideal level varies by sector, the best dividend stocks tend to have payout ratios of less than 75% of their cash flow.

Enterprise Products Partners also shines in this department. The pipeline company boasts one of the highest credit ratings in its sector and its payout ratio has averaged 67% through the first half of 2018.

A person holding out their hand with the word dividends above and an arrow sloping upward.

Image source: Getty Images.

3. They have visible growth prospects on the horizon

The thing that sets the best dividend stocks apart from the rest of the pack is their ability to grow their payout on a consistent basis. To do that, they need to have visible growth prospects. That means they're in an industry with positive growth trends up ahead that will enable them to grow their cash flow so that they have the funds to pay a steadily rising dividend.

Sticking with Enterprise Products Partners, thanks to the growing supplies of oil and gas in the U.S., the company was able to recently finish $5.3 billion of expansion projects, which boosted its cash flow per unit by 27.7% in the first half of 2018 compared to the same period in 2017. Meanwhile, the company has another $5.7 billion of expansion projects under construction and will likely have many more coming down the pipeline, since the North American pipeline sector needs to invest an estimated $800 billion on new infrastructure through 2035 to meet demand. Because of that, Enterprise Products Partners should have no problem continuing to increase its distribution to investors in the future, which is something it has done in each of the last 56 quarters.

The proof is in the outperformance

The best dividend stocks are those that increase their payouts on a consistent basis. To do that, companies need to generate steady cash flow, have a strong financial profile, and visible growth prospects. 

Investors will find all three of those characteristics in Enterprise Products Partners, which is why the company has been able to increase its payout 65 times since going public 20 years ago and appears poised to continue doing so in the years ahead. That growing dividend has been a key fuel behind Enterprise's ability to deliver a more than 1,800% total return since its IPO, which has smashed the 280% total return of the S&P 500 over that time frame. That's why the company serves as a good model for investors to use in guiding them in their quest for the best dividend growth stocks.

Matthew DiLallo owns shares of Enterprise Products Partners. The Motley Fool recommends Enterprise Products Partners. The Motley Fool has a disclosure policy.

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