A common investing mistake is to judge dividend-paying stocks based solely on their yield. I made this error early on in my investing career and it wound up costing me dearly. That's why I've since become an advocate of developing a checklist that can be used to screen out potentially troublesome companies from contention.
With that in mind, here are few must-know metrics to look at before you press the buy button.
Image source: Getty Images.
1. Performance during tough times
Some companies rely on outside factors to go their way to generate a profit (think interest rates for banks, commodity prices for energy companies, or a strong economy for cyclical businesses). Others can crank out predictable profits no matter what is going on in the global economy. I've learned the hard way that it is important to own companies that can perform well during times of market stress, which is why this is often the first thing I look at when I'm going to make an investing decision.
Let's consider two companies to illustrate this point: healthcare giant Johnson & Johnson (JNJ -0.69%) and the energy linchpin Kinder Morgan (KMI 0.27%). Both companies are big, established, and have been paying a dividend for years. Since Kinder Morgan offers up a dividend yield of 2.7% versus only 2.3% for Johnson & Johnson, you might be tempted to assume that it is the better buy.
I felt the same way a few years ago, so I decided to invest heavily in Kinder Morgan. That turned out to be a huge mistake because I later learned that Kinder Morgan's success was dependent on a factor that was outside of management's control: energy prices.
In 2015, oil and gas prices cratered and Kinder Morgan's customers got into a lot of financial trouble. This directly affected Kinder Morgan's financial statements, which ultimately forced the company to cut its generous dividend payment by 75%. While the tide has turned and the company has started to recover, long-term shareholders are still sitting on a big loss.
For Johnson & Johnson, healthcare products tend to remain in demand no matter what is going on in the global economy and the company is so well diversified that its business was barely affected by the Great Recession.
JNJ Revenue (TTM) data by YCharts
This is a major reason why Johnson & Johnson has been able to increase its dividend payment for 55 years in a row. That's a feat that's nearly impossible to pull off if a business relies on outside factors for its success.
2. A sustainable payout ratio
Once I feel good about a company's ability to thrive during tough times I then take a look at its payout ratio. This metric is found by dividing a company's dividend payment by its earnings.
Investors should favor companies with a low payout ratio because it provides the company with wiggle room should something go awry. For that reason, I prefer to pass on companies that have a payout ratio above 80%, even if they have a stable business.
For that reason, I think investors would be best served to eliminate cigarette giant Philip Morris International (PM 1.39%) from contention. While the company's revenue and profits are very predictable, the company's dividend currently consumes 92% of profits. That's far too high for me to feel comfortable.
By contrast, Johnson & Johnson has a payout ratio of 57%, which means its dividend consumes a far lower percentage of its profits. In my view, that gives the company much more financial flexibility, which is an attribute I greatly favor.
3. Good growth prospects
The dividends for great income stocks can be counted on to grow over time. The only way to accomplish that over the long term is to have a growing profit stream. That's why I always check out a company's expected growth rate before I hit the buy button.
Consider IBM (IBM 1.05%) -- the tech giant's profits held up quite well through the great recession and it currently boasts a payout ratio of just 49%. With a dividend yield of 3.6%, it is understandable why this stock has attracted the attention of some income investors.
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However, IBM 's legacy businesses have come under attack in recent years, which is one reason why this company's profits have actually declined by 6% annually over the last five years. While the tide does appear to be turning, market watchers only expect 2.5% profit growth over the next five years. That's not high enough to capture this Fool's attention.
Once again, this is an area in which Johnson & Johnson shines. The successful rollout of a handful of new products over the last few years has allowed the company's profits to grow in excess of 7% annually. What's more, market watchers expect that 7% profit growth rate to persist over the five years thanks in part to the company's $30 billion acquisition of Actelion.
I think that's a far more attractive growth profile than IBM has to offer.
This income stock has it all
Given all of the above, you won't be surprised to learn that I believe Johnson & Johnson is a wonderful dividend stock to own. The company offers investors a recession-resistant business model, a sustainable payout ratio, and good growth prospects. This combination should allow the company's 55-year streak of dividend increases to continue.
The next time you are considering a dividend stock, try running it through this framework to see how it holds. I'm confident that using this checklist will help you pick better stocks and build a more robust income portfolio.
