Four Factors to Find the Best Dividend Stocks

Succeeding with dividend stocks is considerably more complicated than finding the stock with the highest dividend yield and buying. It involves understanding both the business in which one invests and the financials that can sustain the payout.

Many investors are either unwilling or unable to track this. Thus, finding a mutual fund or exchange-traded fund (ETF) specializing in dividend stocks is a viable option for more risk-averse stockholders.

Investors who want higher dividend returns, however, may want to turn to individual stocks. This approach can bring more profit but involves more risk and increased vigilance.

Investors should remember that other than real estate investment trusts (REITs), companies face no legal requirement to pay dividends on their income. For this reason, prospective stockholders need to look for companies with other incentives to maintain payouts.

Investors may need guidance in finding suitable dividend stocks. Hence, prospective buyers evaluating such stocks need to look for four things.

1. Business stability

In the long run, steady dividend streams rely on stable enterprises. Such businesses often fulfill needs that never go away. Companies such as Home Depot and Procter & Gamble have long remained favorites among dividend investors because consumers always need to improve homes or use personal care products.

Companies also need to weather downturns too. An oil company in exploration and production could lose most of its revenue in a downturn, meaningthese companies will struggle to support a stable dividend.

Industries once considered stable can also become unstable. During the COVID-19 pandemic, some REITs have faced questions about their revenue as millions suddenly cannot afford their rent.

Image source: Getty Images.

2. Ability to pay dividends

Such challenges speak to another essential feature of dividend stocks, financial stability. Dividend investors should look for profits that generally increase over time. More importantly, they should look for signs of strength in a company's financial statements. High liquidity, manageable debt levels, and positive free cash flow often point to this stability.

However, one simple measure of a company's ability to maintain payouts is the dividend payout ratio. A dividend payout ratio is the percentage of net income devoted to the payout.

Schools of thought differ on the ideal payout ratio. However, investors generally want to avoid stocks with payout ratios that consistently and significantly exceed 50%. When a payout ratio creeps toward 100% (or perhaps beyond), this could signal that a company may have to slash its dividend to remain financially stable.

Investors should also use a different measure for determining a REIT's ability to pay its dividend. REITs, which must pay out at least 90% of their net income, have payout ratios often exceeding 100%. Instead, REIT investors need to look to funds from operations (FFO) income. Net income includes significant depreciation expenses and other non-cash charges. FFO income adds these charges back, providing a clearer picture of what a REIT can afford in dividends.

3. Dividend increases over time

Another measure of stability is steadily rising dividends. To find a track record of payout hikes, many investors might turn to Dividend Aristocrats, or stocks that have increased their payout every year for at least 25 years. Since many investors and funds own companies specifically for this status, they tend to want to remain Dividend Aristocrats. This increases the likelihood of future payout hikes in these stocks.

Even Dividend Aristocrats are not foolproof, however, as we have learned in past financial downturns. Hence, the Dividend Aristocrat status does not guarantee payout hikes. Moreover, many of the best dividend stocks may choose to keep their payouts stable for a time before resuming increases, so investors should place more importance on financial stability than yearly increases.

4. Finally, the yield

Assuming a company addresses all of the previous concerns, investors may then look for higher dividend returns. The S&P 500 offers an average dividend yield of just above 1.8%. However, investors can find stable dividend stocks well above that average. They may also turn to REITs, a category offering average cash returns of more than 4.3%.

Investors should remember that lower stock prices boost dividend yields in stocks with stable payouts. As we learned during the COVID-19-inspired panic selling in early 2020, stock prices can fall for various reasons. Admittedly, some less stable companies could face financial troubles in an economic slump and cut their payouts. However, these bear markets can also mean higher dividend yields in companies less affected by downturns.

Dividend stocks carry significant risks, however, by understanding both the potential benefits and the perils, an investor can build a portfolio producing long-term growth and steadily rising cash returns.

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Will Healy has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Home Depot and recommends the following options: long January 2021 $120 calls on Home Depot and short January 2021 $210 calls on Home Depot. The Motley Fool has a disclosure policy.

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