When I first started investing, I judged dividend-paying stocks solely on their yield. In my mind, the higher the yield, the better.
Thankfully, I quickly learned that investing in income stocks based on their yield alone is a huge mistake. In fact, a super-high yield can often be a sign of danger. That's why I've been refining my process for dividend stock selection for years, and I now focus on several other factors before making a buy or sell decision.
So what are those factors? Below, you'll find the checklist I use to put a dividend-paying stock to the test.
Test No. 1: Predictable revenue
I'm convinced that the best dividend stocks have control over their top line. After all, companies that depend on factors outside of their control for revenue can see their profits evaporate when the markets take a downturn.
A shining example of a company with predictable revenue is Broadridge Financial Solutions (NYSE:BR). Broadridge helps other companies with record keeping and investor communications by handling boring but mission-critical financial paperwork such as proxy statements and prospectuses. The business was spun off ADP in 2007 and it truly dominates its industry, boasting a market share of roughly 80%. Since companies need to remain in contact with their investors through all market conditions, Broadridge's financial statements are highly predictable.
By contrast, consider the office supply retailer Staples (NASDAQ:SPLS). With a massive yield of 5.2% (more than twice the S&P 500's average dividend yield of 2.2%!), the old me would have been foaming at the mouth to buy the stock. However, Staples' revenue has been declining for years due to the significant pressure from e-commerce companies such as Amazon.com.
Have a look at what has happened to these two companies top-lines over the past five years.
While Staples' management has a plan to help reverse the trend, I don't have any confidence in this company's ability to generate predictable top-line results from here, so I would urge investors to look elsewhere for opportunity.
Test No. 2: A sustainable payout ratio
The next must-know metric for any dividend stock is its payout ratio. This figure is calculated by dividing the company's dividend payment per share by its earnings per share. For example, if a company's annual dividend payment is $1 per share and its earnings are $4 per share, then its payout ratio is 25% ($1/$4).
In general, a low payout ratio suggests that a dividend is sustainable since it provides the company with financial flexibility in case something bad happens. Thus, any stock with a very high payout ratio -- say, above 80% -- should be approached with caution, even if it passes the first test.
For that reason, I've taken a pass on the cigarette and real estate company Vector Group (NYSE:VGR). That might come as a surprise since this company's top line is highly predictable and has been growing for years. With a dividend yield of 7.1%, what's not to like?
That's all great, but Vector Group has sported a payout ratio above 100% for several years, meaning that its dividend payment exceeds its net income. The company has pulled off this trick by turning to the debt markets to fund the difference. While this strategy has worked for some time, its current payout ratio of 262% is a big cause for concern.
By contrast, Broadridge offers up a much smaller dividend yield of 1.9%. However, Broadridge's payout ratio is only 48% of trailing earning, which suggests that its dividend is far more stable than Vector Group's.
Test No. 3: Strong growth prospects
The best dividend stocks not only sustain their current payouts but can increase them over time, too. That why I exclude companies that pass the first two tests but are not expected to grow much over the coming years.
Consider FirstEnergy (NYSE:FE). As a utility, its revenue is highly predictable. In addition, its low payout ratio of 51% suggests that its dividend yield of 4.6% is quite sustainable.
However, FirstEnergy's aging power plants run primarily on coal, so its expenses have been on the rise as it works to reduce its carbon emissions. When mixed with slow but steady declines in revenue, its profits have taken a big hit over the last few years.
Worse yet, market watchers believe this trend will continue for the foreseeable future. Analysts project that the company's profits will decline by more than 5% annually over the next few years. While the Trump administration has taken a pro-coal stance, the long-term outlook for the industry is too tough to ignore. That leads me to believe that this is a stock to avoid.
Yet again, this is a test that Broadridge Financial passes with flying colors. The combination of organic growth and acquisitions should allow the company to grow its top-line by single digits over the next five years. Better yet, modest margin improvements and share buybacks are expected to fuel 12% earnings growth over this time frame.
Given all of the above, perhaps it isn't surprising to learn that I think that Broadridge Financial is a top-notch dividend stock. With a predictable revenue stream, a sustainable payout ratio, and solid growth prospects, this company passes my test with flying colors. That makes Broadridge a strong dividend stock that any income investor could learn to love.
Brian Feroldi owns shares of Amazon and Broadridge Financial Solutions. The Motley Fool owns shares of and recommends Amazon. The Motley Fool owns shares of Broadridge Financial Solutions. The Motley Fool recommends Automatic Data Processing. The Motley Fool has a disclosure policy.