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High-Dividend Stocks: What to Look For and What to Avoid

By Tyler Crowe - Jul 18, 2015 at 12:00PM

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What's better than a dividend stock? A high-dividend stock!

Image source: Images Money via Flickr.

Do you want to put your money to work? Then it needs to do more than just sit in a bank account or get traded in and out of stocks. Your money needs to get you paid, and the way to do that is through high-dividend stocks.

Now, doing that isn't as easy as going out and buying the first high payer you can get your hands on. There are some characteristics to look for that will ensure you'll continue to get paid for years to come. Let's look at why an individual investor should be buying high-dividend stocks, and what you need to seek out and what to avoid when picking these stocks for your portfolio.

Why high-dividend stocks?
Traditionally, a company that pays a dividend has a strong, stable business that generates more cash from its operations than it needs to grow the business. So rather than leave that cash sitting on the books, companies sometimes disburse it to their shareholders. For investors, it's like getting a note every quarter that says, "Thanks for trusting your investment dollars with us; here's some cash for your troubles."

A company that pays a large amount of cash in respect to the stock price is what you'd call a high-yield dividend stock. With the average dividend yield of the S&P 500 at about 1.9% today, I'd say a company considered to have a high-yield dividend has a payout of probably greater than 3.5%.

The reason high-dividend stocks are a great way to put your money to work is that no matter what the market does, you can be reasonably assured that you'll get some sort of return on your investment. For retirees, dividend checks can help you supplement your income without eating into your nest egg. For those who don't need the income from their stocks, the dividends can be reinvested right back into the stock, which increases your share count, which gives your a bigger dividend check next quarter, in a cycle that can be repeated over and over again

It's quite a virtuous cycle.

What makes this kind of investing all the more attractive is that you have to worry much less about the ups and downs of stock prices. With a few exceptions, dividend payouts remain constant or increase from quarter to quarter. That means that your income checks remain constant, or if you're reinvesting those dividends, you're simply getting new shares in the company at a discount. 

"Do you know the only thing that gives me pleasure? It's to see my dividends coming in." -- John D. Rockefeller. Image source: DIREKTOR via Wikimedia Commons.

In fact, some of the greatest fortunes were amassed with the help of dividends. John Rockefeller, the founder of Standard Oil -- which once encompassed major oil companies ExxonMobil and Chevron -- built his personal fortune in large part from the dividends he received from being a major shareholder in Standard Oil and the smaller companies it was broken into. His dividend checks made him the first man to accumulate $1 billion in 1916, which is about $30 billlion in 2015 dollars. I can't guarantee you'll be able to accumulate a fortune like Rockefeller did, but following his example certainly makes sense.

What to avoid in high-dividend stocks
The first thing most people will look at when searching for high-dividend stocks is the high yield. Seeing companies with 7%, 8%, or even 10% yields can trigger an almost Pavlovian response in a dividend investor. However, sometimes yields that high are a sign that the dividend payment is unsustainable. 

See, investing in high-dividend stocks is kind of like that game with the Alpine hiker on The Price Is Right (don't lie; you've seen it). As the hiker gets closer to the top of the mountain from the player making wrong guesses, the greater the risk that he falls off and the player doesn't win that brand-new car! In our case, the higher the dividend yield for a stock, the greater chance there is that the amount of money the company is paying out to shareholders is unsustainable and that the dividend will need to be cut. 

How to keep your high-dividend stocks in check
So if you want to build a portfolio of high-dividend stocks, you want to get your hiker -- er, yield -- high, but without the risk of having it fall off a cliff from a dividend cut. To know whether that payout is sustainable, the most important question you need to ask is this: Does the company's cash generated from daily operations cover (1) its capital expenditures to grow and maintain the business and (2) its dividend payouts to shareholders?

There are a bunch of ways you can tackle this question. Does the company have a history of uninterrupted dividend increases? Is the dividend a management priority? Things like this can be helpful, but a more mathematical way you can measure it is to calculate the company's cash dividend payout ratio. Check out the company's cash flow statement -- which you can find at places such as Yahoo! Finance, Morningstar, or under the "statements" tab if you search for a company on our website above -- and plug the following numbers into this quick equation:

This number is normally represented as a percentage, and any number less than or equal to 100% means the company's business generates enough cash to cover its capital needs as well a pay out all of its dividend commitments. If the number is greater than 100%, then its dividend payment is fully covered and the company needs to do other things to raise cash, such as issue debt, cash in some nonoperational investments, sell assets, or, in the worst-case scenario, cut its dividend payout. 

For an example of how this works, let's take a quick look at ExxonMobil:

ExxonMobil MetricData From Most Recent Financial Statement (TTM, in millions)
Payment of cash dividends $11,746
Net Cash from continuing operations ($38,011 -
Capital expenditures $32,468)
Cash dividend payout ratio 211%

Source: S&P Capital IQ. TTM = trailing 12 months.

Over the past year, ExxonMobil hasn't been able to cover its dividend payment and its capital expenditures from its operational cash flow. During that time, it has received $3.4 billion in cash from divestitures as well as $3.5 billion from investments outside of its typical operations, which have helped cover the cash shortfall. A one-time blip where cash doesn't cover all its capital obligations is OK, but if it becomes a continuing trend, it might be a sign that the company's dividend is reaching unsustainable levels. 

What a Fool believes
High-dividend stocks can be a very powerful tool for investors to build wealth over the long term. Riding that virtuous cycle of reinvested dividends can help to build a formidable nest egg, and it helps you avoid all those taxes and fees from frequently buying and selling stocks. Buying high-dividend stocks works, though, only when you can keep that yield high without having it fall off a cliff, so do your homework and make sure the yield you're buying into today is supported by a cash payout that's sustainable over the long term.

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