Scouring the market for excellent dividend stocks isn't as easy as finding the stocks with the highest yields. In fact, dividend yield is just one of many factors investors should consider when they are looking for the best dividend stocks. To illustrate, I'll analyze two companies whose stocks have meaningful dividend yields: Waste Management (NYSE:WM) and Ford (NYSE:F).
The essential marker of the best dividend stocks is an economic moat. Without a moat, forecasting future cash flow and dividends becomes unreliable. To determine whether a company has an economic moat, you'll need to look for business advantages it has over its competitors, and then find some clear evidence to support your conclusion.
For instance, Waste Management constitutes the largest disposal business in North America. It boasts the largest network of recycling facilities, waste transfer stations, and landfills in the industry. Size like this usually implies that the company benefits from economies of scale. And, not surprisingly, the company's unparalleled dominance in landfill ownership helps it achieve above-average return on equity, at 13%. Compare that to peers Republic Services and Waste Connections at 7% and 9%, respectively.
Our other example comes from the automotive industry, known for its highly competitive environment. In the trailing 12 months, Ford's sales were just 63% of Toyota's, 91% of General Motors, and 53% of Volkswagen's. The auto industry is fragmented in such a way that there really is no obvious leader. Ford's market share in three important markets is representative evidence of the intense competition it's facing: In the U.S., Europe, and China, Ford has about 17%, 8%, and 5% market share, respectively. Ford lacks an economic moat.
With nine years of consecutive dividend increases, Waste Management certainly has a formidable dividend history. But, as the company's growth slows, the prospect of their dividend growth becomes less certain.
Ford has a shorter history of dividend payments, having reinitiated its dividend just over a year ago. But a U.S. recovery has bolstered auto sales and helped the company more than double its 2012 dividend in 2013.
As Fool contributor Daniel Miller points out, Ford's free cash flow levels are still far lower than they were about a decade ago, leaving plenty of room for further boosts to the dividend if free cash flow picks up.
The payout ratio is simply a company's current dividend divided by its current level of earnings. The higher the ratio, the less sustainable the dividend if things go awry. The lower the ratio, the more room for potential dividend boosts in the future.
While Waste Management's payout ratio of 81.7% is fairly typical for a high-yielding dividend stock, Ford's payout ratio of just 17.1% is extremely low. In fact, Ford's payout ratio is even lower than Apple's, a stock I recently dubbed one of the best dividend stocks in the stock market.
Waste Management's dividend yield is unquestionably substantial, at 3.6%. But Ford's isn't too bad either, at 2.57% -- especially taking into account that Ford has considerable wiggle room to boost its dividend in the future.
What would Warren Buffett do?
Asking that question will get you the easy answer. Waste Management is clearly the better dividend stock between these two if you make economic moat a prerequisite in this analysis. Warren Buffett is often known to avoid companies entirely if they don't have a clear durable competitive advantage. In fact, he has particularly voiced his concern about the highly competitive auto industry: "It's very hard to pick -- to pick winners. I don't -- there will be a big auto industry five, 10, 20 years from now that will be selling lots of cars, I just don't know whose cars they're going to be."
If you don't use moats as a requirement, the choice gets a big more intricate. If Ford's free cash flow levels pick up, the company could substantially boost its already meaningful dividend. Fortunately, however, investors don't have to choose between both of these stocks. One smart way to allocate would be to take a large position in the wide moat Waste Management, and a small position in Ford, to potentially capture the upside to dividends if the company does eventually boost its payout more substantially.
There's no formulaic way to finding the best dividend stocks, but carefully looking at the areas outlined in this analysis will get you closer to the bullseye.
Editor's note: In a previous version of this article Ford's dividend was misquoted. The Motley Fool regrets the error.
Fool contributor Daniel Sparks has no position in any stocks mentioned. The Motley Fool recommends Ford, Republic Services, and Waste Management. The Motley Fool owns shares of Ford and Waste Management. 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.