The reasons why it's smart to include dividend-paying stocks in your portfolio are many. Just remember that not every dividend-paying stock is equally promising -- and those with higher yields are not always better than ones with lower yields. Let's take a look at how to find the best dividend stocks.
First, though, a reminder of why you should consider dividends for your portfolio. For starters, they generate income, which is obviously welcome in retirement, but it can also be welcome when you're younger, as dividend dollars can be reinvested in additional shares of stock, building your nest egg.
When the market is in a slump, healthy and growing companies will usually keep paying their dividends, offering some relief in challenging times. And here's something underappreciated: Dividend payers actually tend to perform really well, too. According to Ned Davis Research, for example, dividend-paying stocks averaged an annual gain of 9.3% from 1972 through 2014, while non-dividend payers averaged just 2.6%. Want more? According to Fidelity data, from 1993 through 2014, dividends accounted for about 40% of the 10.3% average annual return of the S&P 500.
Finding the best dividend stocks
Once you're convinced of the value of dividend stocks, how should you go about seeking the best ones? As with any stock candidate for your portfolio, you'll want high-quality companies, with sustainable competitive advantages and great growth prospects. You'll also want them to be attractively valued, as paying too much for a great company isn't a recipe for success. When it comes to the dividend, though, focus on the yield, the dividend growth rate, and the payout ratio.
Yields and growth rates
It's easy to simply zero in on the biggest yields you can find, but remember that a dividend yield is calculated by taking the current annual dividend amount, and dividing it by the current stock price. So, if a stock craters, that will send its yield zooming skyward. Thus, be wary of especially attractive yields, because they may be tied to a stock in temporary or long-lasting trouble.
Once you're considering two or more solid dividend payers, don't just choose the ones with the fattest yields -- because if you're planning to hang on for years, the dividend growth rate can make a big difference. A 2% yield might not seem that exciting today, but if the company has increased its payout by an annual average of 10% over the past five years, and you expect that to continue, in a decade, its effective yield will top 5%. Thus, if Company A's yield is smaller but faster growing than that of Company B, it may be the better choice.
Reasonable payout ratios
Next, check out a dividend payer's payout ratio, which shows the portion of earnings being paid out in dividends. Clearly, a payout ratio of 100% or more would reflect a company without much wiggle room, and with little likelihood of hiking its payout anytime soon. So it can be smart to favor companies with low or reasonable payout ratios, such as perhaps 75% or less.
Don't be too dogmatic about it, though. A company might have a payout ratio of 120%, but only because it had an uncharacteristically bad year. If it's expected to post strong earnings soon, you might worry less about the high payout ratio.
You might also favor consistency. If a company has been paying a dividend without interruption for, say, 65 years, it's going to take that streak seriously, and will want to keep it going. If a company has consistently grown its top and/or bottom line, that can be a sign of effective management and the ability to keep paying dividends.
As you build your wealth with an eye to retirement, give strong consideration to dividend-paying stocks, as they can help your nest egg grow while providing some stability, too.
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, owns no shares of any company mentioned in this article. 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.