Dividends are an essential part of the buy decision for any stock. Some great companies pay no dividend, while some high-yielding companies don't appear to be poised to last for long. Smart investors look to Dividend Aristocrats to offer the best of both worlds.

When stocks offer high yield payouts, what are the hidden risks to watch out for? And what exactly is a Dividend Aristocrat? Join Kristine Harjes and Michael Douglass on today's edition of Industry Focus, financials edition, to get the real deal on dividend stocks.

A full transcript follows the video.

Kristine Harjes: Dividend stocks. What you need to know. This is Industry Focus.

[INTRO]

Hi, everyone. Welcome to Industry Focus, financials edition today. I am Kristine Harjes, and I've got Foolish analyst Michael Douglass sitting right beside me. Michael, welcome to the show. So glad to have you on.

Michael Douglass: Thank you. Very, very kind to invite me back to the show I used to run, huh?

Harjes: Folks, if you're thinking that name sounds familiar you'd be right. And it's not just because of the actor. Michael used to run the show back when it was Where the Money Is, correct?

Douglass: Well, it was right after the name change. The financial one.

Harjes: All right. So, he's familiar with how we do things here on Industry Focus, financials. Michael actually also runs our Wednesday edition of this show which focuses all on health care and if you haven't checked it out it is really fantastic. A lot of good content on there. So, make sure to tune in on Wednesday. I would highly recommend it.

Douglass: Flattery will get you everywhere, Kristine. Thank you. You're very kind.

Harjes: So, I did get to borrow him from the health care to do this financials edition with me today, and I'm sure it's going to be a good one. So, dividend stocks are on our minds today. So, stocks where you're rewarded with cash just for holding shares.

Michael, I'm going to turn it to you for some background info. Why do companies pay dividends?

Douglass: Sure. There are a few reasons. At its core I think that you often see companies coming with dividends when the 'high growth' opportunities have changed over into more of a cash flow machine, right? So, when you've got a company that has done its really fast growth and it's now trying to attract investors with something a bit more stable. Which, in this case, is dividends.

Income investors are very attracted to dividends and so it's a good way for a company to attract those kinds of lower volatility investors. At the end of the day, sometimes you have a company that's just flush with money and they have got to do something with it. You'll often see them return to shareholders either via share repurchases, or dividends.

Personally, I very much prefer dividends -- share repurchases. If your net income is flat and you decrease your share account then your earnings per share will increase. So, that would be the reason to do share repurchases. But those are often really to just zero out management expense and stuff like that.

I tend to prefer cold, hard cash. It's a sign that the company is actually making money. You can't fake cash.

Harjes: Everybody loves cash. That sounds pretty great. So, more cash is a better thing, right? So, is a bigger dividend always better?

Douglass: Not always. One of the things with dividends is -- you'll often see these big yields, and actually, I'll tell you, my very first investment was in this company that had a 12% or 15% yield, or something. I just looked at that and said "Oh my gosh!" Just imagine how quickly I can double my money. One of the key mistakes I made there was, I didn't look at how sustainable the dividend was.

I think if you get any people in a room you're going to get four opinions on what the best way of picking dividends sustainability is. Some folks prefer what's called the "earnings payout ratio", which essentially the percentage of earnings that are paid out in dividends. Personally, I gravitate more toward the cash payout ratio because at the end of the day dividends aren't going to be funded through earnings. They're going to be funded through the cash that you're actually able to generate.

The way you generate that cash dividend payout ratio is essentially by taking the cash operations -- which you can find in the company's 10k, or 10q; they're quarterly, or annual earnings. Then you subtract out capital expenditures. That gives you what's called the 'quick and dirty free cash flow'. Then you divide the amount in dividends paid by the amount of free cash flow.

So, for example, I went ahead and just did this on a piece of paper before we came into the studio. But, Coca-Cola (NYSE:KO) is a dividend stock. In the past 12 months they generated $11.1 billion in cash and operations. Their capital expenditure was $2.4 billion, yielding a free cash flow amount of $8,650,000. They paid out $6.791 billion in dividends. So their cash payout ratio was 78.5%.

Usually you want a lower cash payout ratio because that means that -- volatility happens. Markets happen. Stuff happens to businesses. So, the lower that cash payout ratio is, the more upside there might be. Now, 78.5% is pretty high, but when you think about a really stable business like Coca-Cola, maybe it's not scary high, right?

If you got a -- I don't know. Kristine and I worked together in health care a lot too. So, if you've got a health care company with a huge, or really high cash payout ratio -- 80% plus -- that's not so great.

Harjes: Right. And of course a divided is a marker of the sustainability of the business itself. So, you don't want it to be a faulty flag there. So, how can savvy investors be sure they're not going into a dividend trap?

Douglass: Right. Like I did with my firs stock? I think the key thing first off, is to look at that cash payout ratio because that tells you essentially business today can't sustain the dividend. By the way, the payout ratio on that first stock that I bought -- which I'm not going to name -- was ridiculously high. It was north of 100%. Which is not sustainable given the amount of money you're making.

Harjes: Again, what that means is they were paying out more than they were taking in.

Douglass: Yeah. Exactly. Which is, of course, unsustainable.

Harjes: On the opposite side of that spectrum, sustainability is key and fortunately we've got a whole class of stock that are called 'dividend aristocrats'. They've proven themselves to be really great dividend payers. How does that stock get to join this club?

Douglass: So, essentially you have to pay out increasing dividends for 25 years. So, you have to increase your dividends at least annually, for the past 25 years. The nice thing about that -- in this time -- is that, let's face it; markets happen. Recessions happen, right? So, you'll have stocks have to slash their dividend.

For a company to be deemed aristocrat today, it didn't' slash its dividend in '08, or '09. It in fact didn't slash its dividend in the early '80s when we had another recession. Which means, this company was sustainable, and stable enough to keep increasing its dividend when everything else was falling.

Harjes: Sometimes these increases are pretty small.

Douglass: Of course.

Harjes: But still, keeping a track record like that is a really good way of signaling this is a stable income investment.

Douglass: When you hear the list of companies that are dividend aristocrats you think about it and you're like "I'm really not that surprised." It's companies like Walgreen (NASDAQ:WBA), and Medtronic (NYSE:MDT), Johnson & Johnson (NYSE:JNJ), Coca-Cola. McDonald's (NYSE:MCD) is a dividend aristocrat. These are companies that have been around for -- Colgate-Palmolive (NYSE:CL). They've been around for a while, and they'll probably be around for a while.

That's one of the nice things about that. It's a more stable part of your portfolio.

Harjes: Awesome. So, there are some other categories of investments that income investors will want to be familiar with. Such as REITs and MOPs. Michael, what's the deal with these?

Douglass: With a REIT -- which is a Real Estate Investment Trust -- there are a few different types, but broadly, what REITs do is, they are required by law to pay out 90% of their otherwise taxable earnings out as dividends. In exchange for which, they don't pay income tax. Which is kind of a good deal for them, and a good deal for investors too, because that means you're going to get these really higher yields than you might see otherwise.

HCP, which is one of the big health care REITs is a member of the dividend aristocrats and it pays a 5% yield which is, if not the highest in that index, pretty darn close. That's in part because of that requirement for REITs.

Harjes: That's really impressive to be both on that list, and have a payout that's that high. Clearly it's sustainable. So, does cash flow payout ratio just go out the window for REITs?

Douglass: REITs are a bit more complicated. This is one of those things where -- I think in investing we always try to talk about broad rules and whenever you take a broad rule it doesn't apply as well to others. So, for REITs -- again it depends on whether you're going equity, or mortgage rate. You have to look at the book value. You have to look at rent increases, and that's actually a key part of looking at that dividend sustainability for any company.

You want o not just know about the cash that was generated last year, and the year before. You want to also look at what their growth prospects are. Can they keep bumping cash? Because of course, if they can't then that dividend's going to stagnate at some point. It has to, otherwise they'll do -- that awful first company I invested in -- and have to slash their dividend.

So, you always do want to know those growth prospects. There's never going to be any one thing that tells you a stock is a screaming buy. I would ignore the financial media when they tell you that sort of thing. It's always going to be a holistic look at a bunch of a different things.

Harjes: Makes sense. So, last question for you. We've talked about how great dividends are. Is there a time where you'd prefer a company not pay a dividend?

Douglass: Yeah. When a company has the opportunity to reinvest in its business instead, and get a higher return; that's when I'm going to prefer that it not payout a dividend. So, a good example of this is Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B). This is a company that's been able to grow its book value enormously year in and year out. It doesn't pay a dividend. That's because they're instead using that cash to fund purchases and to invest. And it's working very well for them.

You also see this in a lot of biotechs. Frankly, a lot of the time it's a better deal to a company like a Celgene (NASDAQ:CELG) (NASDAQ:CELGZ), for example, in health care, to keep buying up opportunities to expand its pipeline and to just continue that ridiculously strong growth as opposed to settling into a 1% or 2% dividend and sacrificing a lot of that top line growth potential.

Harjes: Right. So, you see both inorganic and organic growth opportunities. There are times when you might want to see your company spend all of their money pursuing that sort of strategy instead of handing it back to shareholders and hopefully over time that's going to reward you more as the company's value grows.

Douglass: Yeah. Let's face it, Apple now pays a dividend, and I think a lot of us -- certainly as an Apple shareholder -- I see it as a signal that maybe the growth isn't going to be as incredible as it's been the last several years. I'm OK with that. That is a fine trade for me, but maybe not for everyone. So, you have to be aware of those inherent trade-offs when you're pursuing a dividend stock.

Harjes: I felt the same exact way with Gilead Sciences, which I'm a shareholder in Gilead. They announced that they were going to initiate their dividend. I think the announcement came in February. We just had this conversation about how you don't' want to see biotechs paying out dividends.

But for Gilead, it was a marker that this is now a mature company that's generating so much cash that they want to reward their shareholders with it. Maybe you're not going to have the same explosive growth, but it's turning into a more stable company that can generate that sort of revenue.

Douglass: Yeah, and I think that could be an important part of your portfolio, depending on your risk tolerance, depending on what you're looking for, depending on how you feel about companies and the market as a whole.

Harjes: Great disclaimer.

Douglass: Yeah! Well, it's always important because here at The Motley Fool we're always about being Motley in our investing styles. That there should be a lot of different opinions. Just because I share one doesn't mean it's the right one. Just because Kristine says one -- much to her chagrin -- that doesn't necessarily mean it's the right one.

It's always important to do your own due diligence.

Harjes: That's great. Well, I think that about wraps up the time that we have today. Michael, thank you so much for doing the show and giving me plenty of grief on it today. Folks, thanks for listening. There is a ton more information on Fool.com all about dividend investing as well as plenty of coverage on all the companies that we've talked about today.

If you've got any questions for us, any high yield stocks that you're unsure about, or whatever is really on your mind, shoot us an email at industryfocus@fool.com. Looking forward to hearing from you, and have a fantastic week everyone.

As always, people on the program may have interests in the stocks they talk about and The Motley Fool may have formal recommendations for or against. So, don't buy or sell stocks solely on what you hear.

Kristine Harjes has no position in any stocks mentioned. Michael Douglass owns shares of Celgene and Johnson & Johnson. The Motley Fool recommends Celgene, Coca-Cola, and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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.