There are two primary ways to make a profit on a stock that you own. The first way is by capital appreciation (i.e. the stock increasing in price). But the second way is by receiving dividend payments on the shares that you own.
Dividends are cash payments that some companies send to their shareholders (often every quarter). Many investors gravitate towards dividend paying stocks because they can provide a predictable stream of income and downside protection. Those benefits can be especially valuable during times of high market volatility.
While many investors see the value in dividend paying stocks, trying to find the best ones can be a difficult and confusing process. After all, if you search for “best dividend paying stocks,” you may get 50+ different answers from various sites.
But by knowing what to look for in dividend stocks, you can cut through the clutter and quickly find great options on your own. Here are four tips for picking the best dividend paying stocks for your portfolio.
Beware of Sky-High Dividend Yields
So you want to get started with dividend investing. That’s great. But what metrics should you use to determine the value of a dividend-paying stock? Many people would say that the dividend yield is a good place to start.
A stock’s dividend yield is found by dividing its annual dividend by its stock price. So if a stock costs $100 per share and it pays out $2 per year in dividends, the dividend yield is 2% (2 ÷ 100 = 0.2).
Investors love to mine the market for dividend stocks that have high yields. But it’s important to watch out for “dividend traps.” A dividend trap is when you buy a stock because of a high dividend yield only to find out that the stock had other issues that make it a bad buy.
A stock’s dividend yield can significantly increase overnight if the stock tanks because of bad press, like news that the company missed its earnings projections or plans to file for bankruptcy. So a sky-high yield could actually mean that the company is in financial trouble.
The average dividend yield of the S&P 500 is right at about 2%. A higher yield doesn’t necessarily mean that a stock is dangerous. Some sectors (like REITs) are known for paying higher yields, so be sure to compare a stock’s yield with peers in its industry.
However, any stock that is paying over 6% should be heavily scrutinized. And stocks with yields above 10% should almost always be avoided as that’s rarely a sustainable dividend structure.
Look for Long-Term Dividend Growth
Rather than searching for flash-in-the-pan stocks that pay high dividend yields for a short period of time, most seasoned dividend investors play the long game. They want to identify stocks that have not only a strong likelihood of paying dividends for years to come but are also likely to raise those dividends over time.
By buying and holding stocks that have a reputation for raising their dividends, you have the opportunity to make money in three ways: market growth, dividend payments, and dividend growth.
Looking for companies that have a long track record of increasing their dividends? You may want to start with the Dividend Aristocrats. These are companies that have been consistently raising their dividends for over 25 years! Currently, just over 60 companies from the S&P 500 are part of this select group.
Pay Attention to Cash Flow
One of the great things about companies that pay dividends is it’s a strong indicator of financial health. While executives can manipulate how their company’s financials look on paper with creative accounting, with dividend-paying stocks you know that cash is actually being sent to investors.
However, in order for companies to be able to continue sending those dividends, positive cash flow is a must. If a company’s profits are shrinking, it may not be able to sustain its current dividend schedule.
One way to evaluate a company’s cash flow situation is to look at its dividend payout ratios. To do that, simply compare how much it paid out in dividends to its earnings per share (EPS) or free cash flow (FCF).
If either dividend payout ratio exceeds 100%, this means that the company is actually sending more money per year in dividends than it’s earning. Over the long-term, that’s not sustainable. But a dividend payout ratio of 50% could indicate financial health, as the other 50% of profit is being saved or invested back into the company.
Examine Debt-to-Equity Ratios
Investors should be wary of companies with high debt-to-equity ratios for multiple reasons. First, it could mean that the company is at a higher risk of bankruptcy. But even if that’s not a major concern, rising debt payments could force a company to reduce or suspend its dividends.
To find a company’s debt-to-equity ratio, look at its balance sheet, and divide its total liabilities by shareholder equity. Here’s Johnson and Johnson’s most recent balance sheet.
As you can see, as of December 31, 2019, J&J had $98 billion in total liabilities and $59 billion in stockholders’ equity. That’s a debt-to-equity ratio of 1.66 (98 ÷ 59 = 1.66). Appropriate debt-to-equity ratios will vary by sector. But, as a general rule, the higher the number, the more careful you’ll want to be.
Related: The Best Stock Research Tools
Best Online Discount Brokers
- Ally Invest: Best for new investors and those looking for a very easy website to navigate.
- TD Ameritrade: Ideal for more experienced traders looking for a rich set of tools and resources.
- E*TRADE: Offers trading platforms and tools for any investment style.
- You Invest by J.P. Morgan: Best for free trades and cash bonuses.
Read More: The Best Online Discount Brokers
The Bottom Line
The best dividend-paying stocks aren’t usually going to be startups or companies that recently swooped onto the dividend radar. Instead, there’s a good chance the list of best dividend-paying stocks this year will have many of the same names as the list from last year and the year before.
That’s because the most reliable dividend stocks tend to be large-cap blue chip stocks that have enjoyed consistent profits over a long period of time. After all, building a track record of paying out and increasing dividends isn’t possible without long-term positive cash flow generation.
Learn More: How to Start Investing
The list of Dividend Aristocrat companies would be a great place to start your search for strong dividend-paying stocks. From there, feel free to narrow your list based on dividend payout ratios, debt-to-equity ratios, or other financial metrics.