Given paltry yields on savings and high-quality bonds, it's easy to see why dividend stocks are getting more attention these days. Though dividend-paying stocks have a much different risk profile than CDs or Treasuries, a well-diversified portfolio of quality dividend stocks can help boost your current income and provide income growth potential through dividend increases.
Not just any dividend-paying stocks will do, however, and it's important to take a holistic approach to evaluating these opportunities. That's one reason that I created the Dividend Report Card last year, which looks at metrics like dividend history, payout ratios, and interest coverage to determine the sustainability and growth potential of a company's dividend.
Today, I'd like to take a bird's-eye view of dividend health at the sector level and take a gander at oil and gas companies.
According to Capital IQ, energy stocks have been the best performing group in the S&P 500 over the past year, posting 27.9% returns as a group. Much of these gains can surely be attributed to the rise in oil and gas prices over the same period. Last May, crude oil traded for approximately $75 per barrel, and, despite recent volatility, it is changing hands at $100 per barrel today.
Still, the industry has a lot going for it, including increasing demand for energy across the global economy. Large oil and gas companies also have a vast amount of infrastructure, specialized knowledge, and scale that provide them with competitive advantages and significant barriers to entry.
A closer look
The most important factor when considering the health of a company's dividend is the free cash flow payout ratio. In other words, you want to make sure a company has enough extra cash left over after reinvesting in the business to fund the dividend.
That said, let's take a look at the free cash flow payout ratios of some of the sector's top-yielding stocks.
Free Cash Flow Payout Ratio
Royal Dutch Shell
Data provided by Capital IQ, as of May 15, 2011.
FCF = Net income Depreciation-Capital Expenditures-Change in Net working capital.
Foolish bottom line
The results of this quick screen are promising, but it's worth noting that this free cash flow calculation does not include cash acquisitions, an activity in which large oil and gas companies frequently partake. Before investing in any of these companies, it's important to take that into consideration.
The European oil and gas majors are paying higher yields than their U.S. counterparts, but they also tend to pay out more of their free cash as dividends. All things considered, despite their lower yields, the U.S. oil and gas majors appear to have more sustainable dividends with greater growth potential.
Looking for more dividend ideas? Check out our free report " 13 High-Yielding Stocks to Buy Today ."