How to Find the Best Dividend Stocks

Dividend-paying stocks can make your financial life much better in a variety of ways. They can provide regular, dependable income year in and year out, no matter what the economy is doing. They can help support you in retirement with that income -- often without your having to sell the dividend-generating shares. Those dividends will typically grow over time, helping you keep up with inflation, too.

Dividend payers have been shown to outperform non-payers, on average, and they deserve a spot in your portfolio -- perhaps even a big spot. Here's how to find the best dividend-paying stocks.

Image source: Getty Images.

Look for growing, high quality companies

Start by just looking for the best companies you can find. Read widely -- including at sites such as The Motley Fool, where we write about promising companies every day. You might focus on companies with which you're fairly familiar, such as ones in your industry. Or you might focus on ones you can understand well -- that's always smart, because some businesses are far more complicated than others (think biotechnology versus supermarkets or apparel companies), and the better you understand a company, the less likely it is that you'll be surprised by bad news one day.

Among the most promising companies you find, seek the dividend payers among them

Look for solid dividend yields

Next, look for companies with solid dividend yields. Remember that a company's dividend yield is its total annual dividend amount divided by its current stock price. So, for example, if Starbucks (SBUX -1.02%) is paying $1.80 per year (in quarterly payments of $0.45) and it's trading at $104 per share, you'd divide $1.80 by $104, getting 0.017, or a 1.7% dividend yield. That tells you that if you buy into Starbucks now, you'll receive 1.7% of your purchase price over the course of a year: A $5,000 investment would generate $85 in annual dividend income.

Be careful with super steep yields, though -- because they often reflect a struggling company. Remember the dividend yield formula -- if the stock price plunges and the dividend amount holds steady, the yield will rise. If Starbucks were suddenly trading at $90 per share, for example, you'd divide its $1.80 annual dividend by $75 and you'd get 0.024, or 2.4%.

Look for growing dividends

Dividend growth is an important consideration, too, because most good dividends are increased over time -- often annually. They increase at different rates, too. So a company with a 1.5% yield may be a better long-term investment than one with a 3% yield, if the former is growing at an average annual rate of 12%, while the latter is growing at 2%, on average.

Here are some examples of familiar companies, their recent dividend yields, and their five-year average annual dividend growth rate:

Source: Yahoo! Finance, author calculations.

Look for reasonable payout ratios

Finally, check the payout ratio of any dividend stock you're considering. The payout ratio reflects the percentage of a company's earnings that it's shelling out in dividends. Coca-Cola, for example, recently had earnings per share (EPS) over the past 12 months of $1.93, and an annual dividend rate of $1.64 per share. Divide $1.64 by $1.93 and you'll arrive at a payout ratio of 0.85, or 85%, which shows Coca-Cola paying out 85% of its earnings as dividends.

Note that with real estate investment trusts (REITs), it's best to calculate a dividend yield by dividing the annual dividend sum by the trailing twelve months' of "funds from operations" (FFO), as that more accurately reflects income. (The usual EPS number will include depreciation, an accounting item that can be hefty in real estate.)

A low payout ratio is good because it means there's lots of room for future dividend growth. (It might also mean that the company has other pressing needs or preferences for much of its earnings, such as paying down debt, buying back shares, or fueling growth. A high ratio, say, of 80% or 90% or more, reveals not too much room for growth -- though remember that the company's earnings may be somewhat depressed from time to time, such as if it's being challenged by a pandemic. A very high payout ratio -- of more than 100% -- is unsustainable over the long run. It's not a short-term dealbreaker, though, because if earnings are higher in the years to come, the dividend will again become manageable. But otherwise, that dividend will likely be reduced, suspended, or eliminated entirely. Disney, for example, recently suspended its payout, due to COVID-19-related challenges.

So consider including some healthy and growing dividend payers in your portfolio. You'll find plenty to choose from among consumer product companies, financial companies, technology companies, real estate companies, and much more.