Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the railroad industry offer the most promising dividends.

Yields and growth rates and payout ratios, oh my!
Before we get to those companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps greater than $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

  1. The current yield
  2. The dividend growth
  3. The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into railroads
Below, I've compiled some of the major dividend-paying players in the railroads industry, ranked according to their dividend yields:

Company

Recent Yield

5-Year Avg. Annual Div. Growth Rate

Payout Ratio

Guangshen Railways (NYSE: GSH) 2.5% (11.7%) 46%
Norfolk Southern (NYSE: NSC) 2.3% 32.7% 37%
Union Pacific (NYSE: UNP) 1.6% 16% 24%
Canadian National Railway (NYSE: CNI) 1.6% 18.9% 23%
Canadian Pacific Railway 1.6% 13.2% 26%
CSX (NYSE: CSX) 1.5% 42% 25%
Trinity Industries (NYSE: TRN) 1.2% 14.7% 40%
FreightCar America (Nasdaq: RAIL) 0.8% 23.7% NM
Westinghouse Air Brake Technologies 0.1% 0% 2%

Data: Motley Fool CAPS. NM = not meaningful due to negative earnings.

If you focus on dividend yield alone, you might end up with Guangshen, but it's not necessarily your best bet. Its dividend growth rate is negative, meaning that its payouts have actually fallen in the past five years.

Instead, let's focus on the dividend growth rate first, where CSX and Norfolk Southern lead the way. Sometimes, though, growth rates that are so steep are hard to maintain for long.

Just right
In this case, though, with low payout ratios, even the stocks with the highest growth rates still have some room to run. As I see it, Norfolk Southern gives you the best of everything for a dividend stock. Its 2.2% dividend yield isn't huge, but it's been growing briskly and has plenty of room for further growth.

CSX and Canadian National Railway also merit a closer look. They offer at least a little income now, with a good chance of strong dividend growth in the future. Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Do your portfolio a favor. Don't ignore the growth you can gain from powerful dividend payers.

To get more ideas for great dividend-paying stocks, read about "13 High-Yielding Stocks to Buy Today."

Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article, but she does own Burlington Northern through her stake in Berkshire Hathaway. Canadian National Railway is a Motley Fool Stock Advisor choice. Guangshen Railway is a Motley Fool Global Gains selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.