Investing in high-quality dividend stocks is perhaps the most surefire way to build wealth over time, but not all dividend stocks are high quality. In order to narrow down your search, here are three important questions to keep in mind when researching your next dividend stock purchase.
What's the payout ratio?
One of the most basic, yet most important, pieces of data to gather before buying dividend stocks is the payout ratio, which refers to the company's dividend payment relative to its earnings per share. For example, if a company paid out $1.00 per share this year and earned $2.00 per share, it would have a payout ratio of 50%.
In a nutshell, this tells you whether or not a company is earning enough money to cover its dividend, and whether it has the cushion to absorb a drop in earnings and still sustain its current payout rate (or increase it). There's no magic number to look for, but I tend to stay away from dividend stocks with payout ratios in excess of 60%.
The big exception is REITs, which legally have to pay out at least 90% of their earnings. Because REIT earnings subtract depreciation, which isn't actually an expense, they are not a good reflection of how much money these companies are actually making. Instead, when calculating the payout ratio for a REIT, base your math on funds from operations (FFO) instead. A high FFO payout ratio is normal, but look for something considerably less than 100%.
How badly would a recession or industry weakness hurt the company?
The payout ratio is a great indicator of how well a company's earnings cover its dividend payments for now. However, the best dividend stocks are able to sustain or grow their dividends during good times and bad.
The oil industry offers many fine examples of the sort of companies that don't meet this standard. Their earnings were crushed by the drop in oil prices a couple of years ago. Look at Chevron (NYSE:CVX). In 2013, Chevron earned $11.09 per share and paid out $3.90, for a payout ratio of 35%. Two years later, the company's payout ratio had skyrocketed to 175% thanks to falling oil prices.
On the other hand, consider Wal-Mart (NYSE:WMT). The company's business model works well no matter how well or poorly the economy is doing. In prosperous times, people in general are willing to spend more money, which is good for large retailers like Wal-Mart. On the other hand, when a recession hits, people who typically shop at higher-end retailers are forced to cut back, which actually increases Wal-Mart's customer base during tough times. Just look at the company's earnings history -- Wal-Mart actually did better during the great recession in 2008 and 2009 than it did during the economically stronger years before it.
To be clear, I'm not saying that Chevron or any of the other big oil stocks are bad dividend investments, nor that Wal-Mart is necessarily a good one. However, the point is that before investing in any stock, it's important to have an idea about what could happen if things beyond its control go south.
What's the dividend history?
Finally, it's important to check out the history of the company's dividend. High dividends are nice, but high dividends that grow consistently are the holy grail of dividend investing. For example, Wal-Mart, which I discussed earlier, has increased its payout for 41 consecutive years.
As an example of what to look for, consider National Retail Properties (NYSE:NNN), a retail real estate investment trust (REIT) that I own in my retirement account. The stock pays a generous 4.4% dividend as of this writing, but more importantly, the company has increased its dividend payment for 27 consecutive years. This type of dividend growth can help your investment income keep up with inflation over time, and increases the long-term compounding power of your investments.
To find other dividend stocks that have great histories of increasing their payouts, check out the indices that track that subset of companies specifically, such as the S&P 500 Dividend Aristocrats, which only holds S&P 500 components that have increased their dividend for at least 25 consecutive years.
While a stock's past performance or dividend behavior is no guarantee of the future, a history of shareholder-friendly dividend policies makes it more likely that the pattern will continue.
Just a starting point
These are a great starting point, but aren't the only things you should look at before investing. To grow your dividend knowledge even further, check out this list of important dividend metrics and other dividend content from The Motley Fool.