Five Ways to Identify the Most Reliable Dividend Stocks

The mantra that best defines success in dividend investing is “Metrics, metrics, metrics”.

Oct 07, 2024

To win political office, it’s always “the economy, stupid”.

To identify the best real estate, it’s “location, location, location”.

These are maxims that seek to identify the most salient aspects of succeeding in those fields.

For dividend investors interested in securing investments that are the most reliable in their dividend payments, you could say the mantra might be “Metrics, metrics, metrics”.

Not all dividend stocks are created equal, and selecting the best ones requires careful evaluation and examination. In order to identify the most reliable dividend stocks, focus on those dividend indicators and financial data that you can find in the company’s balance sheet and P&L statements.

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Dividend Stocks: What are They?

It’s important to understand what makes a stock a “dividend stock.” A dividend stock is simply a stock that pays regular cash distributions (dividends) to its shareholders. Typically, these are mature companies with stable earnings that distribute a portion of their profits to investors.

Dividend Yield: What is That?

One of the first terms you’ll encounter when analyzing dividend stocks is dividend yield, which is the ratio of a company’s annual dividend compared to its share price. That sounds complicated. Let’s dumb it down a bit, shall we?

For example, if a company pays an annual dividend of $3.00 per share and its stock price is $40.00, the dividend yield would be 7.5%.

$3.00 dividend/ $40 stock price = .075, or 7.5%

While a high dividend yield might seem attractive, it is not the only factor to consider. Sometimes, a high yield might reflect a company in trouble. Sales and revenues could be dropping and investors are bidding the price of the stock downward. The lower the price goes, even if the dividend amount remains the same, the yield will rise.

Dividend Payout Ratio

The dividend payout ratio is another critical metric to consider. This ratio shows the percentage of a company’s net income that is paid out as dividends to shareholders.

Say the company has $100 million in net income in a particular year and it decides to pay out $60 million to shareholders. Since it is paying out 60% of its net income in the form of dividends, its payout ratio is therefore 60%.

A high payout ratio might signal that the company is paying out most of its earnings as dividends, which could indicate limited room for future growth or the possibility of dividend cuts if earnings decline. On the other hand, a low payout ratio could suggest that the company is retaining enough earnings to reinvest in the business, ensuring dividend sustainability.

A healthy payout ratio typically falls between 40% and 60%, though this can vary depending on the industry. Be cautious of companies with payout ratios over 75%, as it might indicate the dividend is unsustainable in the longer term.

Again, take into consideration which industry the company is operating in. Utilities typically have a higher payout ratio than other industries, averaging around 60%.

Technology companies usually have a lower payout ratio, averaging around 35%.

A company's target payout ratio is usually in line with its expected earnings and the target for companies in its industry. Companies make their target payout ratio publicly available.

Key Dividend Indicators

1. Dividend Growth Rate

A company’s dividend growth rate is a good sign of its financial health and commitment to returning value to shareholders. The dividend growth rate measures how much the dividend has increased over time, and consistent dividend growth is a good indicator that the company is profitable and financially stable and will be willing and able to sustain its record of increasing the dividend over time.

Look for companies that have a record of increasing dividends over the last 5 to 10 years. A growing dividend suggests that the company can sustain its dividend payments and has a decent business model. Stocks with increasing dividends often perform well over the long term.

2. Dividend Stability

Some companies offer tempting yields but cut their dividends when they face challenges. To avoid these companies, it’s important to assess dividend stability. A company’s dividend history can provide good insights into its ability to maintain or increase its payouts during economic downturns.

Look for companies that have paid or even increased dividends consistently, even during recessions or market declines. Stocks that maintained their dividends through difficult periods are typically strong, stable businesses with a healthy cash flow.

3. Free Cash Flow (FCF)

As dividends are typically paid from cash, not earnings. Free cash flow is the cash a company generates after accounting for capital expenditures, and it’s a good indicator of whether a company can continue to pay dividends.

If free cash flow is decreasing while dividends are increasing, it might be a red flag. Look for companies with strong and growing free cash flow, as this ensures they have the financial flexibility to sustain and potentially increase the dividend payment.

4. Debt Levels

A company’s debt level is a significant consideration when evaluating dividend sustainability. If a company is highly leveraged (has a lot of debt), it may struggle to maintain its dividend in times of financial stress. High debt levels can also make it more difficult for a company to re-invest in growth or pay dividends. As interest rates rise, as they are now in the process of doing, it becomes increasingly important to gauge a company’s debt and ability to meet its obligations to creditors and bond holders.

Check the company’s debt-to-equity ratio and interest coverage ratio. The debt-to-equity ratio compares the company’s total liabilities to shareholder equity, while the interest coverage ratio shows how easily the company can meet its interest obligations on outstanding debt. Ideally, look for companies with manageable debt levels and a strong ability to pay interest. This bodes well for their dividend stability.

5. Earnings Per Share (EPS)

Earnings per share (EPS) measures a company’s profitability by dividing net income by the number of outstanding shares.

If a company has $200 million in net income and 100 million shares outstanding, its EPS would be considered to be $2.00 per share:

$200 million net income/ 100 million shares = EPS of $2.00 per share

A growing EPS is a sign that the company is generating higher profits, which makes it more likely to sustain or increase dividends.

When evaluating stocks, check for consistent EPS growth over time. Be cautious of companies with volatile or declining earnings, as this could put future dividends at risk. Consider the past 5–10 years as a guide to EPS growth.

Financial Data to Examine

Beyond dividend-specific metrics, it’s crucial to look at a company’s financial statements, particularly the balance sheet and the P&L

Balance Sheet Data

· Assets vs. Liabilities: A strong balance sheet with more assets than liabilities is a sign of a financially healthy company.

· Cash Reserves: Healthy cash reserves ensure that the company can cover short-term liabilities and have excess cash for dividend payouts or reinvestment in growth. As the economy approaches the possibility of a recession, this metric becomes that much more important to track.

Profit and Loss Statement (P&L)

· Net Income: Steady or growing net income suggests the company is profitable and able to pay dividends.

· Operating Margin: A high operating margin, especially in relation to other companies in its industry, shows that the company is efficient in generating profits from its operations.

Free Resources for Analyzing Dividend Stocks

1. Yahoo Finance (finance.yahoo.com) (free to all users)

2. Seeking Alpha (seekingalpha.com) (may require a paid membership)

3. Morningstar (morningstar.com) (may require a brokerage account that grants a complimentary Morningstar membership)

4. Company-Specific Web Site

Make your complimentary choice here.

Your Takeaway

Strong financial data from the balance sheet and P&L statement is crucial for ensuring the company is financially sound and capable of maintaining or growing its dividend.

If you are interested in finding some gems aside from those we recommend to you, let these metrics be your guide.

Other articles you may find valuable reading:

Investing in Realty Income: A Smart Choice for Monthly Dividends

Proper Stock Position Sizing: Key to Portfolio Success

What If No One Ever Sold Even One Share of Stock?

Most Recipients Aren’t Interested in Waiting to Claim Social Security Benefits

Best,

George Schneider

Founder and publisher

Retirement: One Dividend At A Time

Disclaimer: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I am long all RODAT Portfolio names. The Portfolio continues to build dividend income with reliable, dependable equities which have long histories of increasing the dividend.

Retirement: One Dividend at a Time

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