Here at The Motley Fool, we constantly write about our favorite dividend stock ideas, but you may be wondering how we find those top-notch dividend-payers. The universe of dividend-paying stocks is vast, and if you don't know where to start looking, it's easy to become overwhelmed or make the mistake of simply chasing high yields. So we asked our contributors how they find the best dividend stocks out there. Here's what they had to say.
It may seem like the best dividend stocks belong to good companies that pay dividends with big yields. Sure, a big yield is preferable to a small one -- sort of. But consider this: If you're planning to hang on for years, then the biggest yields you find may not be your best choice. You should focus instead on dividend growth.
Allow me to explain why. Check out the two stocks below:
- Stock A: Stock price $25. Pays $1 per share annually. Currently yields 4%.
- Stock B: Stock price $25. Pays $0.50 per share annually. Currently yields 2%.
Stock A probably looks more attractive, with a yield twice as big as B's. But let's set some growth in motion.
Imagine that Stock A's dividend grows by 3% per year, and Stock B's grows by 10% per year. We'll maintain the stock price at $25 to keep things simple, but a healthy, growing company's stock will ideally appreciate over time, too. (If you were to buy these stocks at $25, their future yields based on a $25 stock price will be your effective yields; they'll reflect what you're collecting each year based on your purchase price.)
- In five years, its dividend has grown to $1.16 and it yields 4.6%.
- In 10 years, its dividend has grown to $1.34, and it yields 5.4%.
- In 20 years, its dividend has grown to $1.81, and it yields 7.2%.
- In five years, its dividend has grown to $0.88, and it yields 3.5%.
- In 10 years, its dividend has grown to $1.55, and it yields 6.2%.
- In 20 years, its dividend has grown to $4.82, and it yields 19.3%.
Within just a decade, Stock B's dividend has outgrown Stock A's. You can't know how rapidly a dividend will grow over time, but past dividend raises can give you some hints, and a low payout ratio is also promising. Fast growers can reward you more over time.
As Selena points out, stocks that grow their dividends over time can be extremely lucrative. That's why my first place to start researching dividend stocks is a database that Fool community member Dave Fish maintains, which he calls the Dividend Champions. These stocks all have track records of raising their dividends for 25 straight years or longer, mimicking the qualifications for the better-known S&P Dividend Aristocrats list but also including stocks that aren't part of the S&P indexes. Here, you'll find not only blue-chip stocks that everyone has heard of, but also some smaller companies that largely escape the notice of dividend investors.
The one caution about Dividend Champions is that a stock can qualify without ever paying a high dividend yield -- or even having a reasonable chance of doing so in the future. I therefore tend to pick a minimum yield of 2%-3% to start research. One interesting stock from the list that I've owned in the past is water utility SJW Corp. (NYSE:SJW), which has a 48-year track record of rising dividends and a 2.5% yield. But more than anything, simply having guidelines for starting your dividend research does wonders for helping you forward with a dividend investing strategy.
When I go searching for the best dividend stocks to buy now, I screen for high-yield dividend stocks with low payout ratios. While studies have shown that dividend payers outperform non-dividend-paying stocks, and high-yield dividend stocks outperform low-yield dividend stocks, the best-performing dividend stocks had high yields and low payout ratios, according to a study by Credit Suisse. From 1990 to 2006, Credit Suisse found that, compared to stocks with high yields and medium or high payout ratios, stocks with both high yields and low payout ratios did 5 to 8 percentage points better per year.
To find these dividend stocks, you use a stock screener -- conveniently, I've shared what I think are the best free stock screeners on the Internet.
For high-yield stocks, I generally search for stocks yielding above 4%. It's easy to find high-yield stocks; the hard part is finding ones with both a high yield and a low payout ratio, especially as the market has been up for five years straight.
The payout ratio shows you what percentage of earnings or free cash flow is being paid out as a dividend. While many people just divide the dividends per share by the earnings per share, this can paint a distorted picture. I prefer to use dividends paid divided by the free cash flow of the business. This gives you a more accurate look at how much of the business' cash is being used to pay the dividend.
If the payout ratio is above 100%, the dividend is unsustainable, and something must change. For high-yield, low-payout-ratio stocks, I generally look for payout ratios below 40%.