Before we get into screening for good dividend stocks, there’s one basic measure that you must know – it’s called the dividend yield and it compares companies on dividends.
Let me try and explain this with a simple example. Say there’s a company whose shares trade at $20 which pays 25 cents every quarter as dividends. In a year, the company pays a dollar in dividends, so its dividend yield is simply the total annual dividend divided by its current stock price, as a percentage number – so a dollar divided by 20 in our example, is 5%.
Companies are not obligated to pay dividends on common shares. But among companies that do pay dividends, some pay monthly, most pay quarterly, a few pay every six months or maybe even once a year and yet others pay special dividends without any schedule. So when calculating dividend yield, make sure you adjust for the frequency of payout to get the annual payout amount.
Okay, now that you know that the dividend yield is the dollar payout as a percentage of the stock price, you’ll also realize that the yield will change each time the stock price changes. So if a stock moves higher, its dividend yield moves lower. If the stock drops, its yield goes up.
Now, if a company’s stock drops, its yield may suddenly look very attractive but make sure you look into what caused the stock to drop before you jump in. Make sure it’s not a dividend trap (also see: Value or Value Trap?) where you’re lured in by the higher yield but later find out that the company’s fundamentals have weakened and it’s cutting down dividends in coming quarters.
When screening dividend stocks, look at simple things like:
- Business Fundamentals. Always look at a company’s intrinsic business fundamentals such as continuous revenue growth, strong and consistent earnings, solid free cash flow, low debt levels where interest payments do not eat into earnings, competitive strength, and so on.
- Dividend Frequency. Look for companies that have a long and stable history of paying dividends over time, with dividends central to management’s commitment to shareholders. Look for the regularity with which the company has paid dividends over the past five or ten years. If the payment stream is hit-and-miss, simply drop them. Shortlist only those that have consistently paid dividends quarter after quarter, year after year. You can easily find this information on a company’s website in the Investor Relations section or from analyst reports from your brokerage firm or by simply trying a Google search with something like “at&t dividend history” and you’ll likely get what you’re looking for.
- Dividend Increases. Also look for how dividends have increased over time. It’s always a good sign when companies consistently increase their dividends because it most often reflects growing revenues and earnings.
- Dividend Yield. Look at the dividend yield. You don’t have to calculate this because dividend and yield information for public companies is readily available on sites such as Yahoo! Finance where it is updated automatically based on the company’s share price.
Other things you should look for include the company’s free cash flow after it pays off all expenses, because dividend distributions typically come from what-is-called distributable free cash flow. If a company has high profit margins and low debt, it has more left over to pay shareholders. Also look for the payout ratio which is simply the percentage of a company’s earnings that it pays out as dividends. For example, if a company earned $1.50 per share and paid out $1.00 as dividend, its payout ratio is 2/3rds or 67%. Be wary of companies with high payout ratios at or close to 100% because they may not be saving enough to grow the business and could run out of steam sooner (exceptions include certain types of real-estate investment trusts and master limited partnerships that are required to pay out a high percentage of their earnings as dividends to qualify for federal tax benefits).
Also know that most value-oriented dividend payers are typically in stable, boring businesses with assets that generate boatloads of cash quarter after quarter, in specialized sectors such as real estate investment trusts designed to generate income for shareholders, etc. Think utilities, oil and gas companies, pharmaceuticals, solid consumer staples, etc. For example, once your phone or cable company has laid a line to your home or business, they’re virtually guaranteed a monthly income stream with very little to spend on asset maintenance.
Within the Dow Jones Industrial Average, top dividend payers include telecom companies such as AT&T and Verizon, pharmaceuticals such as Merck and Pfizer, industrials such as General Electric and DuPont, consumer goods companies such as Johnson and Johnson, Kraft Foods and Procter & Gamble, tech giant Intel, spirits vendor Diageo, cigarette maker Altria, and so on.
You can use Google to come up with top 10 or top 100 lists of dividend payers and use free online screening tools. You could also ask your broker if they have dividend screening tools that you can use as an account holder.
But always make sure you look for more than just the dividend yield, make sure you don’t fall into a dividend trap, and always focus on a stock’s business and financial fundamentals.