Many investors chase growth stocks during bull markets. Yet stable dividend stocks are generally more attractive during market downturns since high yields can limit their downside potential. It can be tough to tune out the noise and find the ideal dividend stock, but these simple guidelines might help.
Assess the company's financial health
Investors should hold their dividend stocks for long periods, since dividend reinvestment plans (DRIP), dollar-cost averaging, and compound returns can significantly boost their overall gains. Therefore, investors should seek out companies with long histories, wide moats, and consistent growth in profits and free cash flow (FCF).
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Two classic dividend stocks, Coca-Cola (KO 0.01%) and Johnson & Johnson (JNJ 0.54%), check all those boxes. Coca-Cola, one of the world's top beverage companies, was founded 133 years ago and owns a sprawling portfolio of carbonated and non-carbonated drinks. J&J -- which produces myriad pharmaceutical products, consumer healthcare products, and medical devices -- has been around for 134 years.
Both companies own well-diversified businesses, and their sheer scale puts a wide barrier between them and their rivals. Both companies also generate massive cash flows: Coca-Cola's FCF surged 38% to $8.4 billion last year, while J&J's FCF rose 8% to nearly $20 billion.
Check the company's payout ratios
A company's ability to consistently pay dividends is gauged by its payout ratio, which can be calculated in two ways: as a percentage of its earnings per share, or as a percentage of its FCF (known as the cash dividend payout ratio). The latter is generally more reliable since a company's EPS can be distorted by buybacks.
If either percentage exceeds 100%, the company is funding the dividend from its own pocket, and the dividend could be unsustainable. However, temporary spikes in payout ratios from acquisitions or other one-time events shouldn't be considered major threats.
Over the past 12 months, Coca-Cola paid out 77% of its EPS and 81% of its FCF as dividends. J&J's dividend consumed 67% of its EPS and 50% of its FCF. Those stable ratios indicate that both companies can afford to keep raising their dividends.
Check the company's dividend history
Coca-Cola and J&J are both "Dividend Aristocrats" of the S&P 500, a title given to members of the index which raised their dividends annually for at least 25 straight years. Coca-Cola and J&J have both raised their dividends for 57 straight years.
When a company consistently raises its dividend, it indicates it can consistently grow its FCF and earnings, and it's interested in rewarding long-term shareholders.
Compare its yield to three benchmarks
When we check a stock's yield, we should compare it to those of the S&P 500, the 10-year Treasury, and its industry peers. The S&P 500 currently pays an average yield of 1.9%, so investors should generally aim higher than the broader index.
Investors should buy dividend stocks with higher yields than the 10-year Treasury since the government bond is safer than volatile stocks with comparable yields. That was a significant threat in late 2018 when the 10-year Treasury yield surged above 3%, but it recently plunged to just below 1% after the Fed announced an emergency rate cut in response to the coronavirus crisis. By comparison, Coca-Cola and J&J pay forward dividend yields of 2.9% and 2.7%, respectively.
Source: YCharts
Investors should also compare a stock's yield to its primary competitors. If there's a major gap, investors should compare their financial strength and payout ratios to see if a rival offers a better deal.
Mind the valuations
Demand for high-dividend stocks can soar during market downturns, but that interest can also reduce its yield and increase its valuation. If a stock is trading at a significant premium to its estimated earnings growth, it might be prudent to wait for a pullback.
Coca-Cola expects its earnings to grow 7% this year, but its stock trades at a slightly frothy 24 times forward earnings. J&J anticipates 4% earnings growth this year, but its stock trades at a more reasonable 15 times forward earnings.
This doesn't necessarily mean that J&J is a better dividend investment than Coca-Cola, but it indicates that investors are willing to pay a higher premium for the soda maker, which doesn't face legal headwinds like the healthcare giant currently does.
The key takeaways
There's no perfect formula for buying the right dividend stock. However, carefully assessing a company's financial health, competitive advantages, payout ratio, yield, and valuation could weed out the losers and highlight the better investments.
