Dividends are a great perk of investing -- you can't lose a dividend once you receive it like you can lose capital gains. The problem, however, is that dividend stocks span a wide range of yields and growth rates. Some pay a lot and grow a little, while others pay a little but grow a lot.
So how do you find the best ones? Here are three tips on how to identify the best dividend stocks.
1. Is it a cash cow?
Dividends are cash payments to shareholders, a way for a business to distribute its profits when it has more cash than it knows what to do with. So the starting point to finding the best dividend stocks is to find companies that generate a lot of profits.
A key metric for investors to track in this regard is free cash flow, which measures how much cash a company generates after paying its bills and spending money to acquire or maintain assets like equipment, land, and factories. A company can spend free cash flow in several ways, typically to pay down debt, buy back stock, or return cash to investors as dividends.
Companies that consistently produce a lot of cash flow often make for great dividend stocks. An example would be a consumer staples company like Procter & Gamble. It sells products that people use on a regular basis such as shampoo and toothpaste, so there is a steady demand for its products.
In its fiscal 2021, Procter & Gamble generated $76.1 billion of revenue, converting $15.8 billion of that to free cash flow (for a free-cash-flow margin of 21%). The company has been able to pay and raise its dividend for 65 years straight thanks to steady free cash flow.
2. Is the balance sheet in order?
It's important that a company paying a dividend can actually afford to pay it too. The balance sheet is another factor to consider when evaluating a company's dividend strategy. If it's paying a dividend while running up debt on the balance sheet, that's unlikely to be a winning strategy over the long run.
A company may be forced to eventually cut its payout if the balance sheet takes on too much debt. A quick way to gauge a company's financial health is to compare its net debt (total debt less cash and equivalents) to its EBITDA (earnings before interest, taxes, depreciation, and amortization).
A suitable debt-to-EBITDA ratio will vary from one industry to the next, but in my experience, most companies will continue to pay dividends until their net debt is three to four times EBITDA or higher. Most companies want to maintain "investment-grade" credit ratings from agencies like Moody's and S&P Global and will manage their debt levels accordingly.
3. Is there room for the payout to grow?
Lastly, the dividend payout ratio will measure how easily a business can afford its dividend payouts by comparing dividends paid to earnings generated in a given period. Companies will often set their dividend strategy with a sustainable payout ratio in mind.
If a company carries too high a payout ratio, the dividend is in greater danger of being cut if the business experiences an unexpected setback to its operations. Like the debt-to-EBITDA ratio, a healthy payout ratio is sector dependent, but keeping it below 70% to 80% can serve as a decent benchmark across industries. On the flip side, a low payout ratio also means the company has room to increase its payout over time.
Some investors like high-yielding stocks, while others are attracted to reliable dividend payers with a track record measured in decades. Regardless of your preference, you want to identify companies that can sustain their payouts. Using these tips, you have the high-level tools to evaluate any business and its potential as an income generator in your portfolio.