Dividends are a great source of passive income for those looking to complement -- or replace -- their primary source of income. However, not all dividend stocks are created equal. Before putting your money in a dividend stock, you'll want to make sure it meets certain criteria.
Let's look into how to identify great dividend stocks, and then we'll turn our attention to one stock that's a great choice for income-seeking investors.
How to find great dividend stocks
There are several dividend-specific metrics to consider when looking for great dividend stocks. But first, it's essential to consider the company's financial strength as well as its long-term prospects. After all, if a company is in danger of losing its competitive advantage or is drowning in debt with no end in sight, it is probably best to avoid it, dividends or no dividends. Since most companies aren't legally obligated to issue dividends to their shareholders, slashing (or outright suspending) dividend payments is one of the many ways a company in financial trouble can right itself.
That's why it's so important to discern the signs of coming financial troubles and avoid investing in any companies that show these signs. Of course, sometimes economic troubles appear entirely out of left field. Right now, we're going through tough economic times due to the ongoing COVID-19 pandemic and related economic shutdowns -- something no one could have predicted just six months ago. But even during this crisis, companies with strong balance sheets will generally fare better than the rest, and it is among those companies that investors should look for their top picks of dividend stocks.
Of course, not every great business is a solid dividend stock. To identify excellent dividend stocks, investors should first look at a company's dividend yield. And to make this metric even more meaningful, it is best to compare a company's dividend yield with that of other companies within the same industry, or with that of one of the major market indexes. It is also useful to consider the company's payout ratio, which measures what percentage of earnings a company pays out as dividends. A payout ratio above 100% means a company is paying out more in dividends than it is generating in earnings, which may be a sign that the company in question can't sustain its dividend payouts.
Better yet, investors should consider the company's cash payout ratio. This ratio is preferable since it uses cash flow instead of earnings, and earnings are often manipulated by various non-cash items. Another critical metric to check is the company's dividend history. There's no shortage of publicly traded companies that can afford to pay their shareholders dividends for a few years without interruption or without slashing their dividend payments. But truly great dividend stocks will do so for much longer and will often continue to reward their shareholders by way of dividend increases during a recession, or for that matter, a pandemic.
Let's now turn to a dividend stock that investors would do well to seriously consider: Johnson & Johnson (NYSE:JNJ).
Why Johnson & Johnson is a great dividend stock
Johnson & Johnson -- one of the largest healthcare companies in the world -- has increased its yearly dividend payouts for 58 consecutive years, which makes this company a Dividend Aristocrat. But that's not the only reason why investors can take Johnson & Johnson's dividend to the bank. First of all, note that the company's yield of 2.79% is currently higher than the average yield of the S&P 500, which stands at 2.1%. Secondly, Johnson & Johnson's dividend payout ratio is currently 65.6% -- and its cash payout ratio stands at 49.8% -- giving the company plenty of space to ensure future dividend increases. Further, although the pandemic hasn't spared Johnson & Johnson, the company's fundamentals remain strong.
Johnson & Johnson is one of less than a handful of companies in the U.S. to sport an AAA rating from Standard & Poor's, a sign of financial fortitude. Lastly, Johnson & Johnson's financial performance should remain relatively strong -- although not unscathed -- amid the pandemic. During the first quarter, the company's sales grew by 3.3% year over year % to $20.7 billion, while its net income was $5.8 billion, a 54.6% increase compared to the prior-year quarter. Johnson & Johnson did revise its guidance for the fiscal year 2020 to reflect the negative impact of the COVID-19 pandemic.
The healthcare company had previously announced that it expected its sales to come in between $85.4 billion and $86.2 billion. Now, the company expects its sales to be somewhere in the range of $77.5 billion to $80.5 billion. But as CEO Alex Gorsky said: "Johnson & Johnson is built for times like this. We take a long-term strategic view, which means we're in this for the long haul delivering value to all of our stakeholders."
Dividend-seeking investors can be confident that Johnson & Johnson would be a fine addition to their portfolios and will continue rewarding them with sustained dividend increases for many years to come.