How to Screen for the Best Dividend Stocks

Dividends are a crucial part of low-risk investing

Investing 101: A dividend is a share of profits taken out of the company bank account and delivered directly to shareholders. After all, if the corporation makes a lot of money, why shouldn’t it give some back to its investors?

The frugal investor in you should love this. It’s the equivalent of getting free drinks and appetizers at your favorite bar — a kind of loyalty bonus.

But dividends aren’t just a sweetener for your bank account. They also are important indicators of a company’s health.

Small companies often don’t pay dividends because they need cash to grow. Unstable companies also don’t pay dividends because they can’t be sure profits will last.

And most importantly, a company that pays a decent dividend is trying to appeal to longer-term investors. Since dividends are paid once a quarter, you obviously won’t get the paycheck if you buy a stock today and sell it tomorrow. This kind of long-term stability is crucial for investors building a retirement portfolio to span years, not months, of market antics.

If a stock has a dividend, that’s a good sign. And here’s how you should asses the quality of that dividend:

Dividend Yield

Dividend yield is the percentage of the current share price that will be paid out in annual dividends. For instance, Ford (NYSE:F) pays a nickle each quarter in dividends — or 20 cents annually. Recently, the stock had a price of $12.55. So Ford stock “yields” 1.59% in dividends each year, at least based on the math from this particular stock price and particular dividend amount.

Obviously payouts and pricing change, and so do yields. But the good news is that yield is calculated automatically for you on Google Finance and Yahoo! Finance so there’s no need to constantly carry around a calculator. It’s important to understand how yield is calculated, but feel free to let these websites do the math from here on out.

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So what’s a “good” dividend yield? Well, it’s all relative.

Average yield for the Standard & Poor’s 500 Index right now is around 2%. (The S&P 500 is a well-respected list of 500 large stocks that most Wall Street analysts use as a proxy for the entire stock market.) In the 1980s, the S&P’s average dividend yield was more than double the current 2% rate … but that was a very different time. Yields also vary widely from industry to industry, based on their business models.

But as a good rule of thumb, any company with a yield of less than 1% these days is just paying a nominal dividend for the sake of saying it has one — not because it is offering investors any real income potential. Ideally, you want a stock yielding more than 2%.

Dividend Payout Ratio

Equally important to the size of the dividend is the sustainability of that dividend. That’s where the “dividend payout ratio” comes in.

The payout ratio is the percentage of total profits that is dedicated to dividend payments. For Ford, the company is expected, on average, to earn $1.47 in total earnings per share in 2012. If you divide $1.47 by the 20 cents paid annually, you get 13%.

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You can find that projected EPS total easily on the “Analyst Estimate” page of a company via Yahoo! Finance. There is no automatic calculation of dividend payout ratio, unfortunately, but it’s worth your time to do the math.

Why is this important? Well, because it shows how sustainable a dividend is — and how likely that dividend is to be increased in the future.

In the Ford example, the company clearly can pay its dividend and have a boatload of profits left over. Historically, the dividend payout ratio of the S&P 500 is around 50%. Right now we are in a drought, with payout averages for the index under 30%… but Ford is being overly stingy even when compared with its peers in the current environment!

Is a stingy dividend payout ratio bad? Actually, the opposite is true — because it proves a dividend cut is highly unlikely due to conservative payout ratios and that Ford has plenty of cash flow to increase its dividend in the future, if it so chooses.

The frugal investor in you should respect a company that is being conservative in its payouts but still has a decent dividend yield anyway.

Again, a payout ratio of 50% is pretty fair. Lower than that is attractive because of the sustainability it shows, and higher than that is a bit risky. Obviously if a company is paying out 100% of profits via dividends, there is the risk of a dividend cut if profits slump — to say nothing of the company’s inability to reinvest profits in itself for growth.

No Dividend? Don’t Panic!

Of course, these metrics are all academic if your stock doesn’t have a dividend. But don’t despair. A lack of dividend isn’t categorically the kiss of death. If a company doesn’t pay a dividend, it’s not a sign to quit right out of the gate. Just keep in mind that the company has a higher bar to cross going forward.

Look at it this way: A 2% dividend yield is really a 2% return on your investment baked right in. Even if your investment flatlines for two years, you’ll at least get paid something via the dividends alone.

Apple obviously has more than made up for its lack of a dividend, considering if you invested $10,000 five years ago you would now have a cool $53,000! But not all stocks are destined to outperform the market in the same dramatic fashion – and frugal investors may find comfort in the reliability of dividends instead of crossing their fingers and hoping for the next Apple.

A stock without a dividend isn’t a bad investment, per se, but since you’re relying on the share price alone, there is a much higher standard for these investments

Check out a complete list of Investing 101 articles by Jeff Reeves for more on learning how to invest and pick stocks.

Don’t want to keep clicking? Then download the complete series of Jeff’s educational articles for just 99 cents via his e-book “The Frugal Investor’s Guide to Finding Great Stocks: 11 Free Resources to Help Beginners Identify Fantastic Investments.”

You can also buy a printed copy of “The Frugal Investor’s Guide” for $15.10 via online publisher Lulu.

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