Finding great income stocks would be easy if the only metric that mattered was yield. If that was true, then an investor would simply screen for the highest-yielding stocks they could find and buy whatever pops up. Unfortunately, this is often a recipe for disaster -- a high yield is often a signal that a company is in trouble.
What's an income investor to do? My suggestion is to develop a simple process that weeds out potential duds from consideration. Below, we'll take a closer at the three steps I use to find the best dividend-paying stocks.
Step 1: Is the company's revenue predictable?
Companies can't consistently make dividend payments without first generating a profit, and the only way to generate a profit is to have revenue. However, I've learned the hard way that not all revenue is created equally. If a company depends on a strong economy or high commodity prices to generate revenue, then its investors are setting themselves up for a world of pain once the tide turns. For that reason, I vastly prefer to buy companies that have pricing power and sell products or services that remain in demand through all economic cycles.
Take Johnson & Johnson (NYSE:JNJ) as an example. The company sells thousands of healthcare products throughout that world that remain in demand in good times and in bad. What's more, millions of consumers and doctors know and trust the company's brand name, which enables J&J to price its products at a premium. When combined, these factors help to make the company's top line highly predictable.
By contrast, an energy producer like Occidental Petroleum (NYSE:OXY) has little control over its pricing. The company's top line is highly sensitive to changes in energy commodity prices, which can cause its revenue to violently swing from year to year.
Here's a chart that provides a stunning visual of the variability in these two companies' revenue streams.
As you can see, Johnson & Johnson's revenue has been remarkably consistent over the years. Meanwhile, Occidental's revenue has gyrated violently.
Mind you, this doesn't mean Occidental hasn't been a great stock to hold over the long-term. However, it does show that Occidental doesn't have control over its revenue. For that reason, I can't consider it to be one of the strongest dividend-payers out there.
Step 2: Is the payout ratio sustainable?
Smart dividend investors know that they should always check a company's payout ratio before they move forward. The payout ratio is found by dividing a company's annual dividend payments by its earnings per share. While this metric is far from perfect -- one-time charges can sometimes temporarily distort a company's earnings and, hence, its payout ratio -- this figure does give an investor a quick way to judge dividend sustainability. The lower this number is, the better, as it means that the dividend isn't eating up a large portion of the company's income.
A good rule of thumb is that a payout ratio of 70% of lower is desirable. Anything above 70% should be a yellow flag since it doesn't give a company a lot of wiggle room to pay its dividend if profits were to take a hit.
Let's look at Johnson & Johnson's payout ratio. This figure currently stands at 54%, which means that slightly more than half of its profits are used to pay its dividend. That's a good sign for investors as it suggests that J&J has plenty of financial flexibility to make its dividend payment should its profits ever decline.
By contrast, consider the cigarette maker Philip Morris International (NYSE:PM). This company would sail through my first test because it sells a recession-resistant product, and management isn't shy about flexing its pricing muscle. However, Philip Morris currently boasts a payout ratio of 92%. This means nearly all of the company's profits are currently being used to fund its massive dividend. What's more, this ratio has continuously moved higher over the last five years.
So far, this fact hasn't prevented the company from growing its dividend payment over time. However, it does suggest that future dividend increases might be more challenging to produce.
While I'd never bet against Philip Morris International, I think there are better dividend stocks prospects out there.
Step 3: What's the company's growth potential?
Predictable revenue and a sustainable payout ratio are great traits to see in a dividend-payer, but the best dividend stocks provide investors with growth potential, too. After all, the best dividend-payers are capable of increasing their dividend payment over time. You can't do that without a growing stream.
Let's once again look at Johnson & Johnson. For years, this company has churned out new products that were either homegrown or acquired through M&A. When combined with steady price increases, J&J has consistently increased its profits over time. Looking ahead, the company's recent $30 billion acquisition of Actelion and its full pipeline of drug candidates promise to power J&J's profits higher in the coming years. All told, Wall Street is currently projecting 6% profit growth annually from here, which is pretty good for a massive company like J&J.
By contrast, consider Target (NYSE:TGT). This company would pass my first two tests since its revenue is largely predictable and its payout ratio is only 49%. However, analysts believe that the company's profits are going to decline by more than 5% annually over the next five years as a result of encroaching online competition. While that projection could prove to be overly pessimistic, there's no doubt that the company is facing some headwinds that will make growth tough to come by. In my view, that disqualifies it from consideration.
A great dividend stock
After going through this three-step process, it probably isn't much of a surprise to learn that I believe Johnson & Johnson is one of the best dividend-payers in existence. The company's revenue is predictable, its payout ratio is sustainable, and it offers investors a realistic shot at growth. Mix in a dividend yield of 2.5%, and I think Johnson & Johnson has all the makings of a wonderful income investment.