With benchmark interest rates more or less at 0%, it's tough sledding for anyone seeking lower-risk sources of investment income. Fortunately, there are plenty of dividend stocks out there that are worth a look. But in a world of tight balance sheets and too-good-to-be-true yields, how do you find them?
Choose the right sectors
First, you have to start by narrowing down the universe of stocks out there. You might want to start with sectors where paying out dividends is part of the plan. Historically, this has meant utilities, master limited partnerships (MLPs), and real estate investment trusts (REITs).
REITs and MLPs are generally considered sources of pass-through income to investors and often do not pay income tax at the corporate level. They are generally known for big infrastructure investments, steady earnings, and modest growth. These stocks are generally required to distribute 90% of their income.
2 key metrics
When looking at dividends, the key numbers to focus on are the yield and the payout ratio.
The yield shows you how much a company pays in dividends, relatively speaking. You can find it by dividing the annual dividend amount by the stock price. Bigger is only better up to a point -- if a company's yield is way above its industry's average, that's a red flag. If most of the stocks in a sector yield around 3%, and you find one that yields 7%, you should make sure it can really afford that payout. This is where the payout ratio comes in handy.
The payout ratio is the dividend divided by earnings per share (EPS). If the payout ratio is low, say below 50%, it would indicate the company has plenty of profit left after paying the dividend and it's probably safe. On the other hand, if it's greater than 100%, it could indicate a cutback in the future unless earnings really improve.
Since we're talking about REITs, here's an important point to keep in mind: Earnings per share understates their cash flow because they have a lot of depreciation. So the appropriate metric for REITs is funds from operations (FFO). If you divide the dividend by FFO per share, you'll get the relevant payout ratio.
Working through an example
Good dividend stocks should have a comfortable payout ratio, a steady stream of dividend increases over the years, and growth in EPS. It's helpful to create a table in a spreadsheet and to list all of the stocks in the sector with their yield, payout ratio, price-to-earnings (P/E) ratio, EPS growth, and dividend growth. For now, let's look at commercial real estate REIT Realty Income (O 0.86%) (which happens to pay dividends every month -- unlike most U.S. companies, which pay dividends quarterly).
Realty Income paid total dividends of $2.72 in 2019, which worked out to a 3.7% yield based on its stock price at the beginning of this year. Some REITs pay more, but that's not bad. The company made $1.38 in EPS last year, so at first glance it would appear that the dividend was way higher than earnings. But remember that REITs have a lot of non-cash depreciation charges, and EPS understates their cash flow. So Realty Income's true payout ratio is 82% -- $2.72 in dividends divided by $3.29 in FFO per share. At Wednesday's closing price, Realty Income's price-to-FFO ratio is about 19. From 2018 to 2019, FFO per share grew 5.5% while the dividend grew 2.7%, which would signal lower payout ratios or higher dividends ahead.
There are other considerations when choosing a dividend stock (we care most about what the company will do in the future, not what it did in the past), but this provides a framework for an investor to systematically look at dividend stocks and to find the best candidates for further research.