There is no magic formula for picking dividend stocks, but there is a reliable process. Specifically, there are a few steps to take to find the companies that can give cash back to shareholders, can easily afford it, and are likely to increase the amount each year. Let's look at how to find them.
Dividends or capital returns
First, an investor has to decide if there is a yield that they absolutely require. Knowing that can help filter out a lot of companies that don't make the cut. However, it's important to decide whether share buybacks should count in the yield. After all, when a company buys back shares it is returning capital in the most tax-efficient way. As Warren Buffett says, if you need cash you can sell some shares.
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That choice can have a huge impact on what kinds of stocks you might buy. Apple's (AAPL -1.22%) stock currently has a paltry dividend yield of 0.67%. That jumps to about 4.6% after factoring in share buybacks. The company retired nearly 700,000 shares in the past 12 months, or 3.9% of the shares outstanding.
On the other end of the spectrum is Diamondback Energy (FANG 0.57%). The company offers a healthy yield of 1.75%. However, it has issued a massive amount of shares to make two acquisitions in the past few years. It's standard practice and can be a fantastic use of capital, but those extra shares carry an obligation to pay dividends. It serves as a kind of tax on dividend payers when they issue shares. And they'll keep paying it in perpetuity.
| Apple | FY 2018 | TTM |
|---|---|---|
| Shares outstanding | 20.0 billion | 17.2 billion |
| Dividend per share | $0.68 | $0.82 |
| Dividends paid | $13.7 billion | $14.2 billion |
Data source: Morningstar. FY = fiscal year. TTM = trailing 12 months.
Since 2018, Apple has increased its dividend 20% while the total amount it pays out has crept up less than 4%. It's a different story for Diamondback Energy. Although the company's dividend has skyrocketed in the past few years, so has the amount it pays in dividends. It's performing a balancing act that requires those acquisitions to generate cash sooner rather than later. Otherwise, it might struggle to pay the dividend.
| Diamondback Energy | FY 2018 | TTM |
|---|---|---|
| Shares outstanding | 105 million | 160 million |
| Dividend per share | $0.38 | $1.52 |
| Dividends paid | $37 million | $245 million |
Data source: Morningstar. FY = fiscal year. TTM = trailing 12 months.
Companies that can cover the dividend
That's the next most important thing to look for: How easily can the company cover the distribution? There are a number of ways to measure this. Ultimately, the conservative way is to calculate what percentage of the cash flow is being paid out to shareholders. On this measure, Apple shines again. It's distributing only 16% of its free cash flow as dividends while Diamondback is giving out 60%. Both are safe, although the wild swings in energy prices can cause this metric to fluctuate for a company like Diamondback. In that case it may be best to average multiple years.
AAPL Cash Dividend Payout Ratio data by YCharts
Companies that have been raising the dividend
Finally, if a company is providing enough yield, and can easily cover it with cash flow, an investor might want some assurance that it will grow each year. A history of raising the dividend is no guarantee about the future, but it does indicate a preference. A board of directors that starts raising the dividend each year typically doesn't want to break the streak.
Both Apple and Diamondback have been steadily increasing the per share payouts to stockholders for several years. As long as it is financially prudent, they are likely to continue. Apple's dividend has increased 9% per year since 2013, its first full year after reinstating a quarterly dividend. Diamondback has quadrupled its distribution since 2018. There is no way it can keep up that pace, but it is a clear signal to shareholders that the company is serious about returning capital.
Find the right balance for you
For investors, the best dividend stocks are the ones that provide reliable income over time. To find them, it only takes three simple steps: determining which return metric to use and how much yield you require, making sure the company can keep paying it in the future, and deciding how likely you are to get an annual raise.
Every investor will prioritize those factors differently. Someone with 30 years to invest may only care about how much room there is to raise the dividend. A retiree may prioritize the actual cash received each quarter. Whatever your perspective, be sure to combine these three steps and avoid getting too enamored with any single metric. If you strike the right balance, you should enjoy increasing payouts for years to come.
