Best Dividend Stocks

8 Keys to Finding the Best Dividend Paying Stocks

Are the best dividend stocks high yield stocks? Many novice dividend stock investors seem to think so.

But there are many factors to consider when evaluating dividend investing choices.

Here are 8 such criteria you might want to look at when searching for the best dividend stocks:

#1 - Solid and Consistent Earnings

It's surprising how often this is overlooked. Good companies are profitable companies, whether they're dividend paying companies or not.

Remember that a company's earnings are the backbone of any successful income investor's portfolio. Don't be seduced by high yield stocks just because of the yield. A company's earnings must be solid and consistent if its dividend payout is going to be, too.

One good gauge of a company's earnings is to review how solid and consistent they have been historically. Be sure to review them over the previous five to ten years to see how well they held up under a variety of economic conditions.

Earnings can be manipulated, of course, so it's also a good idea to review related metrics such as cash flow and revenue figures over the same time period.

#2 - Strong Balance Sheet

Strong businesses maintain strong balance sheets. A company with excessive debt should raise two red flags in the mind of the potential investor:

How did the company accumulate the excessive debt in the first place? A successful operation produces lots of cash, not lots of debt.
A company already saddled with debt faces extra headwinds. Heavy debt puts pressure on profits, free cash flow, and the ability to invest in additional growth opportunities.

There are, of course, certain industries that require a capital intensive structure, such as utilities and telecommunications, long favorites of many dividend investors. The question then becomes one of free cash flow and how easily a dividend paying company can service its debt load.

Keep in mind, however, that in periods of unexpected or rapidly rising interest rates, a formerly safe dividend paying blue chip company will be noticeably impacted.

#3 - Long Term Competitive Advantages

The foundation of capitalism is competition, and the most successful companies are those that have an edge.

It could be any number of items including: a significantly high barrier to entry by potential competitors, a vastly superior distribution system, or a particularly strong brand.

I recommend Pat Dorsey's, The Little Book That Grows Wealth for a succinct but powerful discussion of durable competitive advantages.

#4 - Healthy Dividend Growth Rate

The one disadvantage to tracking a dividend paying stock's dividend growth rate is that it only tells you how much the dividend has grown in the past. There are no guarantees that the future dividend growth rate will mirror the past growth rate, especially if the stock has seen recent rapid growth rates.

But still, the historical dividend growth rate, assuming you track it over at least a five year period, will give you a general idea of how successfully the company itself has been growing.

It will also give you a good sense of management's attitude toward, and commitment to, the dividend. Is the dividend growing? Is the dividend growth rate consistent or does it fluctuate with no real pattern?

The best dividend stocks, in my opinion, are those stocks with a dividend that regularly gets raised.

#5 - Sustainable Dividend Payout Ratio

A company's dividend payout ratio is another important metric to consider before investing in stocks with dividends.

The dividend payout ratio is simply the percentage of the total earnings that the dividend payout represents.

A high dividend growth rate is unsustainable if the dividend payout ratio is rising just as fast. Ideally, the payout ratio would remain relatively steady within a certain historical range for that particular stock.

What is a good dividend payout rate?

That depends on various factors. Certain corporate structures such as Real Estate Investment Trusts (REITs), Business Development Councils (BDCs), Royalty Trusts, and Master Limited Partnerships (MLPs) are legally required to distribute up to 90% of their income back to investors in order to avoid having to pay a corporate income tax.

Certain industries have higher (or lower) dividend payout ratios than other industries. The best use of this metric is to compare it to other dividend paying stocks in the same industry.

And, in the short term, the payout ratio will fluctuate wildly if there is a big change to earnings (e.g. a large drop). Use common sense and other analysis to help you determine if a fluctuating payout ratio is a temporary phenomenon or an indication of something more serious.

#6 - Non-Cyclical Operations

The best dividend stocks are not, in my opinion, cyclical stocks. When a company's earnings - and therefore its dividends - are highly dependent upon the business cycle, the income investor is going to take one step back for every two steps forward.

If you're investing for income and you're investing for the long haul, the last thing you want is a business that's only profitable half the time.

The best dividend stocks are those that, as we saw in Criteria #1, are consistent.

#7 - Responsible Share Buybacks

In theory, share buybacks are a wonderful thing. A company uses its earnings to purchase (and retire) shares of its own stock. The result is a reduction of the total number of outstanding shares.

All else being equal, the fewer the number of outstanding shares, the more earnings there will be per share, which should serve to increase the value of your own shares. And this is all done with no tax consequences (unless you sell the stock) since there's no payout.

In actuality, however, I find that most share buyback programs destroy as much value as they theoretically create.

Aside from the notoriously terrible track record most companies have in timing their purchases (i.e. at market tops when everything is all sunny and wonderful), all too often, share buybacks have an even uglier side - as a way to mask or offset the share dilution that occurs as part of stealth executive compensation packages involving stock options.

If the CEO of a company is going to take half the earnings, he or she better own half the company, and it should also be in the form of dividends.

That's not to say that share buybacks are always bad, but the best dividend stocks don't use the practice in shady ways. But when you see companies that are always announcing share buybacks and yet the number of outstanding share never go down in a meaningful way, it's hard not to view the buyback as a subtle form of theft.

#8 - Shareholder Friendly Management

The best dividend stocks, like the top stocks in general, have shareholder friendly management.

What does that mean?

It means they either have a demonstrated commitment to investors or enough shares in the stock themselves to align their interest with yours.

Ultimately, shareholder loyalty means that management runs the business in the best long term interests of the company since that's what will create the greatest value and most sustainable dividend over the long haul.

Final Thoughts

Obviously, there's considerable overlap with and relationships between these criteria. Use your best judgment and common sense when evaluating stocks paying dividends.

It is interesting to note that the prerequisites for determining the best dividend stocks, can also be applied to most investments.

That's because the best investing, the truest form of any investing, for that matter, is long term investing.