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How to Find the Best Dividend Stocks

By Lawrence Rothman, CFA - Jan 22, 2021 at 9:20AM

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Going through a simple process can help you separate the dividend stock wheat from the chaff.

If you are on the hunt for solid dividend-paying stocks, the search can overwhelm you. That's because there are so many from which you can choose. Before you jump in, there are a few important criteria to understand that will help you choose high-quality companies that will keep making payments, even through difficult days.

It may seem daunting, but the opportunities certainly exist. You just need to know what to look for before you invest.

Follow the earnings

Companies that are able to generate steadily higher earnings have no trouble continuing to pay dividends. Ideally, a company has sufficient earnings to reinvest in the business and reward shareholders by returning a portion as dividend payments.

A man holding bills fanned out in one hand and pointing straight ahead with the other.

Image source: Getty Images.

One way to see how a company is balancing earnings and reinvestment is by looking at its payout ratio. This is the percentage of earnings the company pays out as dividends. There's no specific percentage to watch to determine if a payout ratio is too high. But know that a payout ratio above 100% means a company is paying out more than it's earning. Investors should look at this figure over time to see if it increases significantly. That rise could indicate that the company's payments are becoming unsustainable.

For example, Costco (COST 5.65%) has increased its earnings per share from fiscal 2015's $5.33 to $9.02 last year. This allowed it to raise its regular dividends from $1.70 per share to $2.70, and the payout ratio was in the 30% range (a figure generally thought to be quite sustainable). The company's fiscal year ends in late August or early September.

Cash flow is important

Increased earnings should translate into more cash flow. You should look at a company's operating cash flow, and then subtract capital expenditures. This provides the free cash flow rate. When comparing this amount to the dividends it pays, you should see that it can continue to comfortably make the payments.

Continuing with Costco, its operating cash flow was $4.3 billion in 2015, and the company grew that to $8.9 billion in 2020. After spending $2.8 billion on capital expenditures last year, there was $6.1 billion of free cash flow. This was a large cushion to pay the $1.5 billion of dividends. Costco produces so much cash flow that the board of directors has declared large special dividends, including a $10-per-share payment in December.

A history of growing dividends

While past performance is no guarantee of future results, it does provide investors with some reassurance when companies have a long history of increasing their dividends.

Dividend Aristocrats are S&P 500 companies that have raised their dividend payments each year for at least 25 straight years. As of July, there were 66 companies on that list. This is a good place to start, since these companies have a proven track record of hiking dividends through all kinds of economic environments, and even during the current pandemic.

If you want to narrow it down further, you can look for Dividend Kings. These are companies that have increased dividends annually for a minimum of 50 consecutive years. This list includes familiar names like Coca-Cola (KO 0.36%) and Johnson & Johnson (JNJ -0.09%). These 27 companies have an even more impressive record.

Investing in dividend-paying stocks may not offer the most exciting returns. But it does offer steady income that helps your total return. If you're interested in these types of companies, it's important to narrow it down to the ones that you can rely on to keep paying ever-increasing amounts.

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Stocks Mentioned

Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$464.99 (5.65%) $24.88
The Coca-Cola Company Stock Quote
The Coca-Cola Company
KO
$64.30 (0.36%) $0.23
Johnson & Johnson Stock Quote
Johnson & Johnson
JNJ
$179.46 (-0.09%) $0.16

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

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