Holding Money

Photo: Flickr user Steven Depolo

When selecting dividend stocks, there is no shortage of options. A quick search shows there are 2,653 stocks on the NASDAQ or NYSE paying dividends of 1% or more. In order to narrow down your search and focus on the best dividend stocks for you, it's important to know the right metrics to evaluate.

The three most important metrics
When evaluating a dividend stock, its yield is only one piece of the puzzle -- there are two other important metrics that help put the dividend yield into context:

  1. Dividend yield -- This is the most obvious and lets you know how much you can expect to get paid per year as a percentage of your original investment. For example, if you buy $1,000 worth of a stock with a 3% dividend yield, you can expect dividend payments of $30 over the next year. Contrary to popular belief, this is probably the least important of the three metrics to long-term investors.
  2. Dividend growth -- A stock's current yield is important, but if it stays constant over the years, inflation will eat away at your income stream. For this reason, it's important to look at a stock's history of increasing its dividend, and this means looking at two pieces of information. First, does the company consistently increase its dividend? And how rapidly does the dividend grow over time? With dividend growth, it's important to keep in mind that a company's past behavior doesn't guarantee the pattern will continue, though it does make it more likely.
  3. Payout ratio -- This lets investors know how much of a company's profits get paid to shareholders as dividends and is usually expressed as a percentage. For example, if a company earns $1.00 per share and pays a $0.60 annual dividend, its payout ratio is 60%. A lower payout ratio indicates that the dividend is safe, even if the company's revenue drops. It may also indicate that the company reinvests more of its profits in order to grow its business.

Two examples
With these three metrics in mind, let's take a look at two popular dividend stocks: AT&T (NYSE:T) and Johnson & Johnson (NYSE:JNJ). Neither of these is a badinvestment choice, but they are completely different investments, as a look at the metrics reveals.

AT&T is an excellent choice for current income, with a 5.5% annual dividend yield as of this writing, and also has a 30-year history of consistent dividend increases. The company has grown its payout by an average of 4.2% per year over the past two decades, which should help investors' income keep up with inflation. But since AT&T isn't highly focused on growth, it pays out the majority of its earnings (72%) to shareholders.

As a result, AT&T is a good choice for investors who want a high level of current income and want to keep up with inflation but aren't too concerned with future growth.

On the other hand, Johnson & Johnson has a much lower 3% dividend yield but looks to be a better candidate for future growth. It has increased its payment every year for over five decades and the average annual increase over the past 20 years has been an impressive 11.7%. So, not only is Johnson & Johnson likely to keep up with inflation, but it could handily surpass that -- giving you more purchasing power as time goes on. As you can see from this chart, the difference in annual dividend increases can make a big difference over long periods of time.

T Dividends Paid (TTM) Chart

Additionally, Johnson & Johnson has a significantly lower payout ratio of 48.7%, based on its projected 2015 earnings. This implies that Johnson & Johnson has more room to maintain and increase its dividend no matter what the economy is doing, and also that it is a more growth-oriented company, choosing to reinvest more of its earnings in the business.

So, while both of these are solid dividend stocks, they have different characteristics and work best for investors with different objectives. AT&T is probably the better choice for investors who want a high level of current income from their investments, such as retirees, while Johnson & Johnson could be a better choice for younger investors who aim to build a portfolio (and income stream) for the future.

A starting point
Just because these are the most important metrics doesn't mean they're the only metrics you should look at. Once you've used these three pieces of information to narrow the field down to a manageable list, there are plenty of other numbers and facts to look at in order to determine which stocks belong in your portfolio. For example, you could use any or all of the following information to thoroughly compare potential dividend stocks:

  • P/E, P/S, P/B ratios
  • The health of the company's industry
  • Revenue and earnings growth
  • Debt and interest coverage
  • Share buybacks
  • Beta (volatility)
  • Dividend frequency

The bottom line is that the important metrics should be used to narrow down the choices. But once you've narrowed down the thousands of dividend stocks to a shorter list, it's important to dig deeper into your top choices to get a complete picture of the stock so you can assess whether or not it makes sense for you.

Matthew Frankel owns shares of AT&T.; The Motley Fool recommends Johnson & Johnson. 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.