Discerning investors like dividends. As John D. Rockefeller reportedly said, "Do you know the only thing that gives me pleasure? It's to see my dividends coming in." It's hard to argue with that, as dividend-paying stocks generate actual cash for their shareholders. Not all dividend stocks are alike, though, of course, so spend some time learning how to find the best dividend stocks.
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Why you want dividend stocks
It's easy to dismiss dividend stocks, assuming the dividends they generate will pale compared to the massive profits coming your way from growth stocks. That's wrong-headed thinking, though, because for one thing, dividend stocks can be growth stocks, too. Not only do they kick out cash to shareholders on a regular basis, but as long as the companies remain healthy and growing, their share price will also appreciate over time. Oh -- and even the dividends themselves will be likely to grow over time, too. PepsiCo's dividend, for example, has averaged annual growth of 8% over the past five years, while Hasbro has upped its payout by an annual average of 11%.
Dividend income can help you sleep better. Image source: Getty Images.
Not sold on dividends yet? Consider this: Dividend stocks tend to outperform other stocks. According to Ned Davis Research, from 1972 through mid 2016, dividend-paying stocks that consistently increased their payouts averaged an annual gain of 9.8% vs. 7.3% for dividend payers that held their dividends steady, and just 2.3% for non-dividend payers. Indeed, from 1986 through 2015, dividends accounted for about 33% of the 7.9% average annual return of the S&P 500, according to data from S&P Dow Jones Indices.
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How to find the best dividend stocks
So, how should you go about finding the best dividend stocks? Well, one thing to not do is look for the highest dividend yield you can find. High-yield dividends are sometimes tied to slow-growing companies, and many times, a yield is fat because the stock has slumped thanks to temporary or long-lasting challenges facing the company. (Remember, the dividend yield can be thought of as a fraction -- calculated by dividing the annual dividend amount by the current stock price. Thus, if the stock price drops, the yield will get bigger.) There's no need to avoid more reasonable yields such as payouts of 4% or less. Stocks with smaller yields can reward you well -- especially if they're growing briskly. If you're looking at a 3% yield from a relatively quickly growing company and a 6% yield from healthy but slow-growing company, the 3% dividend might soon be paying you more than the 6% one if it's being increased at a faster rate.
The best way to start looking for the best dividend stocks is to look for healthy, growing, promising companies -- because all payouts will be tied to how successful the underlying company is.
Once you have some promising dividend stocks to consider, focus on their yields vs. the amount of the dividends. (Dividend yield is calculated by dividing the annual dividend amount by the current stock price.) A $2.00-per-share annual payout might look better than an $0.80-per-share one, but if the former stock's share price is $100, that's a 2% yield, while the latter stock's yield might be 4% if the share price is $20.
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Be sure to consider how rapidly each dividend you're considering is being increased over time. Favor companies with strong dividend growth. As an example, imagine buying a stock for $40 per share that is paying $1.00 annually in dividends. That's a 2.5% yield. But if that payout is increased by an annual average of 8% over the next decade, it will end up paying you $2.16. Divide the $2.16 dividend by your original purchase price of $40 per share, and you're looking at an effective yield of 5.4%.
Finally, consider the payout ratio, which reflects the portion of a company's earnings that's being paid out in its dividends. If it's, say, 70% or less, there's ample room for continued dividend growth. If it's 100% or more, there's no room for growth -- or error -- and perhaps the dividend will even end up reduced.
Seeking dividend stocks for your portfolio is a savvy move because they're likely to help it increase in value over time, generating income regularly that you can reinvest for more growth.
