Dividends are a great way to generate income without having to sell stocks. But a dividend doesn't automatically make a stock better or worse. The best gains in the market over the past two years have come from technology stocks, many of which don't pay dividends at all.
However, some of the best long-term investments are solid companies that pay stable and growing dividends. Here's your survival guide for finding the best dividend stocks -- including what to avoid and what to look for.
1. Behind every dividend is a company
High-yielding dividend stocks can be tempting. After all, a dividend yield of 10% or more is higher than the average return in the stock market. It looks like easy money. But a 10% yield will provide little consolation if a company cuts its dividend or its stock falls more than its dividend payment. Peter Lynch, who ran the best-performing mutual fund from 1977 to 1990, used to say: "Behind every stock is a company. Find out what it's doing." It's important to remember that stocks are simply the instrument by which to invest in a company. A small dividend or no dividend from a good company is better than a high dividend from a terrible company.
2. Paying a dividend with debt is a red flag
There are plenty of cases of small, unknown companies with over 20% dividend yields that end up going bust or cutting their dividend. But artificially high dividend yields can happen to big companies, too. Take the example of BP (BP 0.54%).
On Aug. 3, 2020, the day before BP would announce earnings, its shares were trading around $21 and had an annual dividend of $2.52, or 12% a year. The dividend yield wasn't supposed to be that high. Just a year prior, the company was trading for around $35 a share with a yield closer to 7%. Buying a company just because its dividend yield is high and its stock is down isn't good enough. A little research would have shown you that BP had arguably the worst balance sheet of the oil majors. Facing mounting debt and an earnings collapse, BP cut its dividend in half the next day. What happened next may surprise you.
Instead of selling off, its shares rose over 6% as investors praised BP's dividend cut and its new direction toward renewable investments. And it still yielded an attractive 5%. Over the past year, BP's net long-term debt position has fallen 18%. Contrast this improvement to ExxonMobil (XOM -0.65%), which did not cut its dividend. Its net long-term debt is up close to 25% in one year, and is now the highest in the company's history. Recording historic writedowns and declining earnings, Exxon is straining its balance sheet by paying a dividend it can't afford.
3. Look for companies that support their dividends with free cash flow
The first two lessons provided words of caution. Now that you know what to avoid, let's talk about what to look for.
A healthy balance sheet with low debt and tons of cash provides a great foundation for dividend raises. Stable and growing free cash flow (FCF) is another metric to look for. FCF is the cash left over after expenses have been paid. It can be used to pay down debt, buy back shares, and pay dividends, among other things. FCF that regularly exceeds dividend payments is a good sign that the business can afford to pay its dividend without relying on debt. There are plenty of dependable stocks that do just that. In fact, companies that raise their annual dividends for at least 25 consecutive years earn a spot on the list of Dividend Aristocrats.
4. Dividend cuts can be a good thing
At first glance, dividend cuts can seem like a red flag, but this isn't always the case. As we saw with BP, cutting the dividend was a good thing for its balance sheet. But BP has long-term problems, and the dividend cut doesn't automatically make it a good investment. In some examples, cutting a dividend isn't only the best decision, but it can actually be one reason to buy an undervalued company.
In its fiscal year 2019 (which ended Sept. 28, 2019), Disney (DIS 0.17%) paid two semi-annual dividends of $0.88 per share, or $2.9 billion in total. In early May 2020, the company announced it was suspending its dividend, a blow to its reputation as a reliable blue chip stock. But Disney was facing an unprecedented collapse in two of its largest revenue streams -- theme parks and movie theaters. The dividend cut proved to be the right decision. Disney lost $2.4 billion in fiscal year 2020 compared to a profit of $10.9 billion in fiscal year 2019. Instead of straining its balance sheet by depleting cash or taking on debt, the dividend cut saved Disney a payment it couldn't afford. Investors recognized the long-term strength of the Disney brand and attributed its losses to the COVID-19 pandemic. The massive success and growth prospects of Disney+, and the idea that the rest of its business would come back, culminated into a market-beating year for Disney and sent its shares up 25% to a new all-time high.
On the surface, dividend increases sound good and cuts sound bad. But the reality is much more nuanced than that.
More important than a stock's dividend is the strength of the company. A dividend attached to a strong company can be the cherry on top of an already great investment. A high-yielding dividend from a bad company can be misleading and result in financial losses. Applying these lessons to your own portfolio should help you select good dividend stocks and avoid money-losing endeavors.