John Rockefeller once said, "Do you know the only thing that gives me pleasure? It's to see my dividends coming in." But you don't need to be a tycoon to know that holding dividend-paying stocks is a sound strategy for producing steady income from your portfolio.
Unfortunately, stock investing offers no guarantees. Just because a company has distributed money regularly to its shareholders in the past doesn't mean it will keep doing so, nor can you be sure it will maintain its payout level. However, there are some prudent steps you can take to increase your odds of picking high-quality dividend stocks that won't leave you disillusioned.
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A strong balance sheet
It may seem strange to look at a company's balance sheet when examining whether it can continue paying dividends. However, it's important to check to see whether it has the financial resources to survive the inevitable tough times.
Take Johnson & Johnson (JNJ -1.04%), which has strong financials. In fact, it has a AAA-credit rating from the major agencies, one of only two companies with that distinction. As of the end of the first quarter, it had $24.6 billion in cash and marketable securities and long-term debt of $30.3 billion on its balance sheet. That strength will allow Johnson & Johnson to withstand any hiccups, such as the issues it had with its COVID-19 vaccine. In April, its board of directors raised the quarterly dividend by 5% to $1.06, increasing its streak of payout hikes to 59 straight years.
On the flip side, AT&T (T 1.88%) has accumulated a lot of debt by making several big acquisitions. It had $11.3 billion of cash and $180.2 billion in debt on the books at the end of the first quarter. The company, which typically boosts its dividend in January, has kept it unchanged thus far this year.
After looking at the balance sheet, if it meets your satisfaction, it's time to check into other factors.
Track record
If a company has continually paid dividends for many years, or even better, raised them annually, that's a good sign regarding its commitment to its payout.
To narrow your search to the most dedicated dividend payers, you can look at the Dividend Aristocrats -- members of the S&P 500 that have increased their payouts for at least 25 straight years. Or, you can scour the shorter list of Dividend Kings -- companies that have raised their payouts every year for at least half a century.
Look to the future
This leaves us with the most important question for income investors, which is whether a company has the ability to continue paying higher dividends. You can check a couple of key figures to make this determination.
The first is a company's payout ratio -- the amount it pays out as dividends in relation to its net income. Certainly, corporate income can fluctuate from one year to the next, but it is important to see a fairly steady rate over time. Of course, a payout ratio over 100% for any extended period of time should be a warning flag for investors.
For instance, last year, Colgate-Palmolive's (CL 0.43%) payout ratio was 56%, and the company has generally held that metric in the mid-50% to low 60% range for the last few years. This seems sustainable, particularly since the company has a stable business, selling items like toothpaste, toothbrushes, and soap. Indeed, it's a Dividend King.
Checking Colgate's 2020 free cash flow, the $3.3 billion it generated was more than enough to cover its $1.7 billion dividend commitment.
It doesn't take a deep dive into a company's financials to determine whether it will be able to continue paying dividends. Once you have gone through your checklist, it is also important to avoid companies emitting warnings signs that their dividend isn't secure. For instance, if a stock offers a particularly high yield, that could indicate that its business prospects have worsened, depressing the stock price. And a weakening business could mean payout cuts are coming.
Avoiding the clunkers and picking high-quality dividend-paying stocks will leave you in the enviable position of generating an ever-growing income stream from your portfolio.
