Warren Buffett's long-term performance in the stock market is unmatched. Since becoming CEO of Berkshire Hathaway (BRK.A -0.28%) (BRK.B -0.68%) in 1965, the company's stock has risen a staggering 2,419,900% and posted compound annual gains of more than 20% between 1965 and 2021.
One of Buffett and Berkshire's keys to success is leaning on dividend stocks during turbulent times. Owning dividend stocks provides Berkshire with a steady stream of income that it can pile back into stocks, letting time and the power of compound growth work in its favor. Over the next year, Buffett's company will collect $6 billion in dividend income.
If you're looking to generate passive income of your own, here's how you can evaluate dividend stocks, along with four Buffett-approved dividend stocks you can buy today.
Image source: The Motley Fool.
How to evaluate dividend stocks
Dividend stocks can be excellent for generating cash flow, but it's important to understand that not all dividend stocks are created equal.
When evaluating dividend stocks, most investors look at the dividend yield. Some stocks pay high dividend yields of 5% or more. While these can give you nice chunky payments, you must be careful that the high yield doesn't come at the expense of stock price appreciation.
This is why total returns matter. If a company pays out a high dividend yield, but the stock price keeps falling, you aren't getting a good return on your money. For example, Annaly Capital Management pays a high yield of over 10% annually, but over the last 10 years, its total returns (stock price appreciation and dividend payouts) have vastly underperformed the broader market.
SPY Total Return Level data by YCharts
Don't chase high yields. Your best bet is to approach stocks like Buffett does and invest in companies that:
- Have sustainable competitive advantages with wide moats.
- Generate cash flow and consistently grow earnings.
- Reward investors regularly through dividends and share buybacks.
While these companies tend to have lower dividend yields, they can be an excellent source of passive income and stock price appreciation, the two keys to growing your portfolio over the long term.
Let's look at four Buffett-approved dividend stocks you can buy today.
This banking giant will pay Berkshire nearly $1 billion in dividend income
Bank of America (BAC -0.13%) is one of Berkshire's largest holdings and will earn it over $909 million in dividend income this next year. Bank stocks can be solid dividend payers because of their consistent earnings and conservative capital management.
Bank of America's strength is its recognizable brand and sheer size. Its $2.4 billion in assets makes it the second-largest bank behind JPMorgan Chase. Over the last two decades, Bank of America's average dividend yield was 2.77%. It currently delivers a dividend yield of 1.45%. That suggests the stock price is doing well (yields and stock prices rise and fall in opposition to each other).
Dividend-paying banks can be a stable source of income, but one thing to keep in mind is that banks can struggle during economic contractions. For example, following the Great Recession, banks were forced to slash dividends and hold them low for years. More recently, Bank of America paused dividend increases during the pandemic because of uncertainty about how it would impact the economy.
One thing working in banks' favor today is higher interest rates. Banks make money on the difference between interest earned on loans and interest paid out on deposits, known as net interest income (NII). Bank of America is one of the most interest rate-sensitive banks, and it saw its NII grow 22% last year. If the Federal Reserve keeps interest rates higher for longer as it fights inflation, banks will keep raking in interest income and delivering for investors.
Buffett is betting on this dirt-cheap bank to bounce back
Ally Financial (ALLY 0.13%) operates as an all-digital bank and is a top auto loan provider in the U.S. Ally has seen auto lending slow down in the past year, while its net charge-offs have ticked up slightly.
What makes Ally an appealing dividend stock is just how cheap it has gotten. In December, Ally traded at a steep discount to its book value, and almost every metric had it at its cheapest valuation since going public. Despite its recent 50% run-up in stock price since mid-December, it remains cheap and trades just below book value.
It appears Buffett is taking the long view, and he sees Ally as a bank that has grown consumer deposits for 54 consecutive quarters and benefits from the rising interest rate but is navigating a temporarily tricky environment. Ally's current dividend yield is a juicy 3.53%, and its cheap valuation makes it a good value stock play.
American Express's powerful brand and robust customer base give its dividend stability
American Express's (AXP 0.07%) powerful brand is associated with luxury. By focusing on premium customers, American Express has higher credit quality and can better ride out economic downturns. Its rewards programs are so appealing that customers are willing to pay nearly $700 annually for access to an American Express Platinum card.
The company added 12.5 million new card accounts last year, and its efforts to appeal to a younger demographic paid off, as millennials and Gen Z made up its fastest-growing segment. The company grew faster than competitors Visa and Mastercard and guided for strong earnings growth in the next year as it plans to make its operation even more efficient.
American Express recently boosted its dividend by 15% to $0.60 per share, giving investors a yield of 1.36%.
Chevron has rewarded investors by growing its dividend for decades
Chevron (CVX 0.44%) operates in a highly cyclical industry where companies can see earnings fluctuate wildly from quarter to quarter based on the price of oil and gas. What sets Chevron apart is its balanced business, where it operates both upstream and downstream businesses. These businesses make it less vulnerable to oil and gas prices -- and an excellent source of cash flow and dividends.
CVX Dividend data by YCharts
Chevron has raised its dividend payout for 35 consecutive years, a testament to its balanced business model and stellar capital management. Last year it generated free cash flow of over $37 billion, and it is using this cash to grow dividends, buy back stocks, and pay down debt. Chevron recently boosted its dividend by 6% to $1.51 per share, giving it a dividend yield of 3.5%.
Final word
Dividend stocks are an excellent source of passive income for investors. It's important not to chase high dividend yields. Instead, you want to invest in good companies with strong competitive advantages and histories of growth -- and these four Buffett stocks are excellent places to start.
