These are tough times for income investors. With interest rates back around zero, typical vehicles like corporate bonds often don't pay enough return to warrant the risks being taken. In that sort of environment, dividend stocks can do some of the heavy lifting of providing income, while still providing some capital gains. So how do you find quality dividend stocks?
Regulated utilities are extremely stable companies
The first step to finding good dividend stocks is to look in the right sectors. Companies with extremely predictable income streams are the most likely to pay a high dividend. As a general rule, this means companies with large amounts of fixed assets.
The classic example of this would be a public utility like Duke Energy (DUK -0.28%), which provides electricity and natural gas to customers in the Southeast and the Midwest. Regulated utilities are natural dividend payers because their business is highly predictable. They generally have a monopoly, and their rates are set by a group of regulators at the state level. The rates are set high enough that the utility is pretty much guaranteed a profit, but not high enough to gouge consumers.
Duke Energy pays a quarterly dividend of $0.965 and just raised its dividend last March. At recent prices, this works out to be an annual yield of 4.4%. Companies that continually raise their dividends are great candidates for an income portfolio.
Another important concept is called the payout ratio, which describes the percentage of net income that is paid out as a dividend. To come up with the ratio, divide the annual dividend by expected earnings per share. In Duke's case, it pays an annual dividend of $3.86, and is expected to earn $5.20 this year. This means the payout ratio is $3.86 divided by $5.20, or 74%. For most companies, this would be on the high side, but regulated utilities have such a predictable income stream, they are able to sustain high dividend payments.
Paying great dividends is a REIT's job
Real estate investment trusts (REITs) are also great dividend payers. REITs are able to avoid paying income tax at the corporate level, provided they pay out at least 90% of their income as dividends. This avoids the double-taxation issue that affects most companies, where the company pays taxes on its income at the corporate level, and then investors pay taxes on the distributed income. REIT income is only taxed once.
One of the most famous REITs is Realty Income (O -1.10%), which calls itself the Monthly Dividend Company. It's one of the Dividend Aristocrats, a collection of companies that have a steady record of yearly dividend increases over at least 25 years (another good place to start when searching for good dividend-paying candidates). Realty Income pays a monthly dividend of $0.235 and increased it twice in 2020. At recent prices, it has a dividend yield of 4.5%.
Realty Income is another asset-heavy company. It's in the business of buying up large single-tenant buildings and then renting them out under a long-term lease. Realty Income concentrates on companies with extremely stable businesses that are less sensitive to economic conditions. Its biggest tenants include Walgreens, 7-Eleven, Dollar General, and FedEx.
REITs have slightly different rules for working out the payout ratio. If you took Realty Income's annual dividend of $2.82 and compared it to the $1.39 the company is expected to earn next year, you'd think its dividend was completely unsustainable. But the way net income accounts for real estate depreciation understates the actual cash flow of a REIT, so most REITs use funds from operations (FFO) instead. In Realty Income's case, the company just reported adjusted FFO of $3.39 per share, so the payout ratio is really closer to 83%. This is about normal for a REIT.
Historically, REITs, utilities, the big integrated energy companies, and pipeline partnerships have been good dividend payers. They tend to have stable earnings and a lot of assets.
There's always a catch
What are some red flags? The most obvious one is when a company's yield is way in excess of its peer group. This was the case in early 2020 when Wells Fargo's dividend yield was twice that of its peer group. Wells eventually cut its dividend.
The other red flag is a company that is in decline. Businesses that had their heyday decades ago and are experiencing little to no growth are ones to approach with caution. If a company's dividend yield seems too good to be true, it probably is.
That said, investors who are looking for yield should be able to find many excellent candidates by focusing on those with a history of raising dividends, a highly stable business model, and payout ratios that are not pushing 100%.