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

Countless individual investors who were burned in the bubble of the late '90s once again find themselves holding stocks that make promises instead of paying dividends. Folks are welcome to take their chances on non-dividend-paying Chinese Internet stocks in ultracompetitive industries such as Sohu.com (NASDAQ:SOHU) and KongZhong (NASDAQ:KONG), but why risk losing your capital when you can make more money not doing so?

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 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 omelet, 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 jumped from about 100 points to 1,250 points -- more than a 1,000% increase -- from 1980 through 2005. That's a hefty bull market. And during that time, dividend payers outperformed non-payers by more than 2.6 percentage points 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 $300,000 -- which is $120,000 more than your dividend-shunning neighbor.

Getting to hope you like me
So how can you find great dividend stocks yourself? It's not based on yield alone. If that were the case, we'd all be holding declining businesses like General Motors or companies with questionable management teams like American Italian Pasta (NYSE:PLB). 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 dropped through the floor.

To throw those out, we've got to do our homework. When you hit the books, keep in mind that 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).

Fortunately, there's a lot of cash out there in today's market. U.S. corporate earnings have been on a tear since pulling out of their nosedive three years ago. The result is that companies have 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, to maintain their tax-advantaged status, real estate investment trusts (REITs) such as Trizec Properties (NYSE:TRZ) are required to pay out 90% of their earnings in the form of dividends, so they will have high payout ratios. Growth-oriented operations like UPS (NYSE:UPS) and Intel (NASDAQ:INTC) tend to pay out less. The two companies paid out just 38% and 23% of earnings, respectively, in 2005.

Then there are the generous dividend payers in the banking and utility arenas. Wachovia (NYSE:WB) paid out 48% of earnings last year, for example.

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 subscribers of my Motley Fool Income Investor service:

  • REITs with a funds from operations (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 I use to screen the selections that make it into my dividend newsletter, 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 50 superior stocks, and you can click here to try the service free for 30 days. You'll enjoy immediate access to my two latest recommendations, which will be released today at 4 p.m. EST.

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 he can hum the other half. He does not own shares of any company mentioned. Intel is a Motley Fool Inside Value recommendation. The Fool has adisclosure policy.