Finding the best dividend stocks to invest in now can be easy if you know where to look. There are many approaches to dividend investing. Beginners frequently start off by simply assuming that higher-yielding dividend stocks are better than lower-yielding dividend stocks -- and there is actually some basis to this. In The Future for Investors, Jeremy Siegel looked at the returns of the S&P 500 from its inception in 1957 to 2002. His research showed that over those 45 years, the highest-yielding 20% of S&P 500 stocks outperformed the S&P 500 by three times.
However, the method I'll introduce is the best. Read on to see why.
How to find the best dividend stocks now
There's a better way to find quality dividend payers than chasing high yields. A study by Credit Suisse found that from 1990 to 2006, stocks with both high dividend yields and low payout ratios had significantly better returns than the broader market and even all other dividend stocks. Compared to stocks with high yields and medium to high payout ratios, stocks with high yields and low payout ratios performed 5 to 8 percentage points better per year, respectively.
For those who aren't familiar, the payout ratio measures what percentage of earnings or free cash flow is being paid out as a dividend. The easiest way to calculate the payout ratio is to divide dividends per share by earnings per share. However, earnings per share can be distorted and thus frequently aren't a great measure of the health of the business. A better measure of the payout ratio is the free-cash-flow payout ratio, as this looks at how much cash is actually being brought into the business. You can calculate the FCF payout ratio by dividing dividends paid by free cash flow.
If the payout ratio is above 100%, that's a red flag, as the company is paying out more in dividends than it is making in income. While this can be sustained for a short time, the dividend will eventually have to be cut if nothing changes. A payout ratio above 70% is quite high, though it's not necessarily bad if the company does not need to reinvest much of its earnings into the business. A low payout ratio of 40% or less signals that the dividend is sustainable, the company is choosing to reinvest its cash flow elsewhere, and there is plenty of room for the dividend to grow.
To find dividend stocks with low payout ratios, you can use a stock screener such as those found in this list of the best free stock-screeners. A good current example is Spanish telecom Telefonica (NYSE: TEF), with a dividend yield of 6% and a payout ratio of 34%, according to Finviz.
An important note about high-yield stocks
Dividend yields and stock prices move in opposite directions. A high yield sometimes means that investors have begun to worry about the business and driven down its stock price. High-yield dividend investors succeed over the long term because they are able to buy these depressed stocks for low valuations.
However, keep in mind that the studies mentioned above looked at large numbers of stocks, so you can't just pick a few top-yielding dividend stocks and expect to enjoy the historical outperformance of the category as a whole. If you aren't willing to do the stock screening and research to find high-yield dividend stocks on your own, there are a number of dividend ETFs that you can invest in, such as the Vanguard High Dividend Yield ETF (NYSEMKT: VYM), the iShares Core High Dividend (NYSEMKT: HDV) ETF, and the PowerShares High Yield Equity Dividend Achievers (NYSEMKT: PEY) ETF. Each will provide you with a diversified collection of dividend stocks, but keep in mind that none of them specifically follow the high-yield, low-payout-ratio strategy.
It doesn't take a complicated strategy to beat the market. The key is to find a strategy that works and stick to it over the long term. By investing in strong companies with outsize dividends, reinvesting those dividends in more shares, and holding them for the long run, you can handily beat the market over time.
Dan Dzombak can be found on Twitter @DanDzombak, on his Facebook page DanDzombak, or on his blog.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.