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How to Find the Best Dividend Stocks

By Selena Maranjian – Oct 10, 2020 at 7:01AM

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It's hard to beat the power of dividends -- here's how to zero in on great ones.

If you're ignoring dividend-paying stocks in your investing, you're doing your portfolio a big disservice. Consider, for example, a 2013 J.P. Morgan Asset Management report that looked at companies that regularly made (and increased) dividend payouts and companies that paid no dividends between 1972 and 2012 -- and found quite a difference: The average annual gain for the payers-and-increasers was 9.6%, while it was just 1.6% for non-payers.

Such outperformance has held true in other studies and reports, too, to varying degrees. Not all dividends are equally attractive, of course, so here's a look at three things you can do to better zero in on the best dividends.

Rolled-up dollar bills seemingly sprouting from the ground

Image source: Getty Images.

1. Look for high-quality companies

First off, be sure that you stick to good or, better yet, great companies. Lots of companies pay dividends -- indeed, close to 400 of the 500 companies in the S&P 500 index do so, per the folks at indexArb.com. But those companies vary widely in their attractiveness as investments.

So what makes for an attractive stock investment? Ideally, you want a great company that's trading at a great price. You'll often know a great company when you see it. Researching the company, you'll see that it will have little to no debt, or its debt will be very manageable; will, ideally, have fat profit margins and growing revenue and earnings; will likely be a leader in its field, or maybe it will be a younger, smaller company disrupting an industry; and will have a compelling business model and competitive advantages.

For example, Apple has a switching-costs advantage, in that once its customers have one or more Apple devices, it will be a hassle to switch to a different digital ecosystem. Like companies such as Disney and Coca-Cola, it also has a strong brand. When consumers see a product by any of those companies, they will likely think positively of it, trusting it to be of good quality.

It's a bit harder to discern what a good price is for a stock. For best results, learn how to value stocks, getting some useful math under your belt. But you can also get a rough idea of value by using some simple measures such as price-to-earnings (P/E) or price-to-sales (P/S) ratios. If a company's P/E ratio is 20, for example, and you see that its P/E has ranged from 18 to 31 over the past five years, averaging 25, you'll see that it appears to be relatively undervalued. If two very similar companies have P/E ratios of 12 and 19, the one with the lower P/E would appear to be more of a value.

2. Look for meaningful yields

Next, naturally, you want to favor higher dividend yields. But tread carefully: Sometimes a high yield is due to a stock having crashed. Remember that a dividend yield is simply the result of dividing a company's annual dividend amount by its current stock price. When the stock price rises, the yield drops, and vice versa -- it's basic math.

It's not uncommon to see dividends in the low- to mid-single digits, but when you see a dividend that's unusually high, do some digging into the company to see whether its price has fallen significantly and whether the company is going through any hard times.

3. Look for growing yields

Finally, assess how quickly a company's dividend is growing, and factor that into your decision-making. If you hope to hang on to your next investment for many years, a good company with a dividend that's yielding 2% now and that's been growing at 12% annually over the past few years can be a smarter buy than another good company with a 3% yield that's only been growing at 5% annually.

Be sure to consider keeping a portion -- and perhaps a large portion -- of your portfolio in dividend-paying stocks. If you have a portfolio with a total value of, say, $400,000, and an overall average yield of 3%, you're looking at annual income of about $12,000 -- a sum that's likely to increase from year to year.

Selena Maranjian owns shares of Apple and Walt Disney. The Motley Fool owns shares of and recommends Apple and Walt Disney and recommends the following options: long January 2021 $60 calls on Walt Disney and short October 2020 $125 calls on Walt Disney. The Motley Fool has a disclosure policy.

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Stocks Mentioned

Walt Disney Stock Quote
Walt Disney
DIS
$95.69 (-3.22%) $-3.18
Apple Stock Quote
Apple
AAPL
$144.22 (-2.63%) $-3.89
Coca-Cola Stock Quote
Coca-Cola
KO
$62.70 (0.02%) $0.01

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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