Dividend-paying stocks outperform the market over time. That's a fact -- and the reason I write a dividend-oriented newsletter. But so many investors forget this important lesson.

Countless individual investors were burned in the bubble of the late '90s, but once again find themselves holding stocks that make promises instead of paying dividends. Folks are welcome to take their chances on companies like Novell (NASDAQ:NOVL) or ANSYS, but why take on all that risk when you can make more money without it?

Getting to know you, getting to know all about you
Dividend stocks are most likely to make real products and provide real services that create real cash flow. They then pay some of this real cash flow out to real shareholders in the form of real dollars. You can then choose to reinvest those real dollars into additional shares of real company stock or take them down to the grocery store to buy a carton of eggs and make yourself a real omelette or go on a vacation and get yourself a real sunburn.

Much of that could explain why dividend-paying stocks have performed so well over the long term. But because dividend-paying stocks are often viewed as safer investments, the common perception is that they tend to underperform non-payers in heated markets. While this was true during the Internet-driven craze of the late '90s, it hasn't held true for other periods.

The S&P 500 index has jumped from about 100 points to today's figure of just over 1,200 -- more than a 1,000% increase -- from 1980 to today. That's a hefty bull market. And during that time period, dividend payers outperformed non-payers by more than 2.6% per year. While that may not sound like much, if you'd invested $10,000 in dividend-paying stocks in 1980, today you'd have nearly $119,000 more than your dividend-shunning neighbor ($278,004 to $159,105).

Getting to hope you like me
So how can you find great dividend stocks yourself? I'll tell you that it's not based on yield alone. If that were the case, we'd all be holding dogs like Friedman Billings Ramsey (NYSE:FBR) and Delta Galil. A high yield is not always a good yield. Indeed, some of the highest-yielding stocks -- like the two mentioned -- exist only because their prices have fallen through the floor.

To throw those out, we've got to do our homework, and here's how to hit the books. The best place to start is cash. After all, that's what we seek as dividend investors: companies that generate extremely large free cash flows (FCF).

You're going to have a good time with this one in today's market because there is a lot of cash out there. U.S. corporate earnings have been on a tear since pulling out of their nosedive three years ago. The result is that companies are reloaded, and they're ready to fire at share buybacks, mergers, and acquisitions, and -- you guessed it -- higher dividend payouts.

After you check out the cash situation, make sure your company isn't paying out more than it can handle. The metric for that is the payout ratio, and you want to look for different numbers depending on the class of investment.

For instance, in order to maintain their tax-advantaged status, real estate investment trusts (REITs) such as Vornado (NYSE:VNO) are required to pay out 90% of their earnings in the form of dividends, so they will have high payout ratios. Growth stocks as Wal-Mart (NYSE:WMT) or McDonald's (NYSE:MCD), on the other hand, might pay out as little as 15% to 30% of their FCF.

Then there are the generous dividend payers in the banking and utility arenas, such as Bank of America (NYSE:BAC) and Income Investor pick United Utilities (NYSE:UU), which often have a payout ratio in the 50% to 75% range.

There's no magic payout ratio appropriate for all companies, but here's the rule of thumb I use to find market-beating investments for Income Investor's thousands of subscribers:

  • REITs with an FFO payout ratio below 85%.
  • Higher growth common stocks that pay out less than 50% of FCF.
  • Banks that pay out less than 60% of FCF.
  • Regulated utilities that pay out less than 80% of FCF.

The Foolish bottom line
Of course, there are many other criteria that I use to screen the selections that make it into my dividend newsletter, Motley Fool Income Investor, such as exactly where the company's cash is coming from (e.g., operations or borrowings), the quality of its management team, a material yield, and a reliable dividend track record. To date, I've used that criteria to identify more than 40 superior stocks that are beating the market by 10 percentage points, and if you click here right now, you'll be able to access today's brand-new issue when it is released at 4:00 p.m. EST. There is no obligation to subscribe.

This article was originally published on Feb. 7, 2005. It has been updated.

In addition to picking winning dividend stocks for Motley Fool Income Investor , Mathew Emmert can whistle half the songs in The King and I and hum the other half. He does not own shares of any company mentioned, although he previously owned shares of Friedman Billings Ramsey. The Fool has adisclosure policy.