As of July 2014, there were over 600 companies with market values greater than $500 million and a yield above 3.5 percent trading on the U.S. stock exchanges. The range of industries, tax consequences and future prospects from this number of stocks allows an investor to put together a stock portfolio that fits her financial goals. Understanding dividend stock evaluation criteria puts you on the path to picking your personal best dividend stocks.
Follow the Cash
A company pays dividends out of the profits or cash flow it generates from operations. Evaluate dividend safety by comparing the dividend rate to the cash available. For corporations, the dividend payout ratio, the dividend percentage to net income per share, is a popular metric. For example, a stock that earned $2 per share in net income and pays a $1 dividend has a 50 percent payout ratio. Companies using tax-advantaged business structures, including real estate investment trusts and master limited partnerships, must pay out 90 percent or more of net income as dividends. For these companies, compare the dividend rate to free cash flow per share. REITs report funds from operations to show the cash available for distribution, and MLPs call it distributable cash flow. FFO and DCF are often much higher than the reported net income per share, providing a margin of dividend safety.
The Yield vs. Growth Spectrum
Many dividend stocks increase the dividend rate on a regular basis. Faster dividend growth will come with a lower yield but better long-term total return potential. For example, you may prefer a stock with a 5 percent yield that is expected to grow by 8 percent per year instead of an 8 percent yield with a low probability of any increase. Pick dividend stocks based on your goals for shorter- or longer-term income needs.
Buying Dividends for the Long Term
Do not focus just on yield when selecting dividend-paying stocks for your portfolio. Primary considerations should be whether the business generates sufficient and excess cash flow to support the dividend and the prospects for future dividend increases. A dividend reduction comes with a double hit of a much lower share price when the news of the cut hits the market. A stock with a history of recent dividend increases is much less likely to cut the payout than one that has paid the same dividend rate for a period of years.