- Many investors look for high dividend stocks, but high dividend yield is only half the formula. The highest yield stocks do not perform best.
- Credit Suisse showed how a formula involving two key dividend metrics – dividend yield and payout ratio – could help you buy stocks that dramatically outperform the market.
- From 1990 – 2006, the best-ranked dividend stocks generated an annual return of 19.2% versus 11.2% for the S&P 500 – beating the benchmark by 8% percentage points per year.
What if two key numbers could uncover the best dividend stocks?
In a 2006 research paper, the Credit Suisse Equity Research team showed how analyzing two key dividend metrics – dividend yield and payout ratio – could help you buy stocks that dramatically outperform the market.
First, let’s look at the basics: What are dividend yield and payout ratio?
What is Dividend Yield?
Dividend yield is a simple ratio of the annual dividend a company pays per share divided by its current share price. It answers the question, “If I were to buy this dividend stock at today’s price and collect its dividend for a year, what percent return would the dividend offer me compared to how much I paid for the stock?”
For example, if you buy Apple (AAPL) stock today at $224.29 per share and you hold it for one year, you will earn a dividend of $2.92 for every share you purchase (assuming their dividend stays flat for the year). That $2.92 dividend equals a 1.3% return on the price you paid for the stock ($2.92 dividend / $224.29 stock price = 1.30% dividend yield).
Of course, the share price will change every day, so the dividend yield will fluctuate every day. And if a company keeps their dividend rate steady (or growing), the dividend yield will get larger the more a company’s share price falls.
For this reason, undervalued stocks often offer two benefits for the price of one: undervalued shares PLUS a high dividend yield.
But dividend yield is only half the formula. While research shows stocks with high dividend yields tend to outperform, we have to also consider payout ratio.
What is Payout Ratio?
Payout ratio measures how much a company is paying out in dividends vs. how much money the company made in earnings. It’s essentially a measure of dividend sustainability because it examines whether a company is paying out too much in dividends compared to how much it’s making through its regular business operations.
Let’s look at GE as a (painful) example. Over the last five years, GE’s average payout ratio has been 188%, which is sky high. That means they’re paying out FAR more in dividends than they’re earning as a business.
In general, a top dividend stock should aim to keep its payout ratio below 50% so they’re retaining at least half of their earnings to reinvest in the business.
Payout ratio can fluctuate in the short term as earnings change (although dividends tend to stay relatively steady), which is why it’s helpful to look at a longer term trend.
The Best Dividend Stocks Offer a High Yield with a Low Payout Ratio
Researchers at Credit Suisse found that stocks that combine high dividend yield and low payout ratio tended to dramatically outperform other dividend stocks. Put simply, these are companies that can easily afford to pay a high dividend yield.
Conversely, the worst performing stocks were those that had a low yield and a high payout ratio. Put simply, these are companies that can barely afford to pay a low dividend yield.
From 1990 – 2006, the high yield with low payout ratio stocks generated an annualized return of 19.2% versus 11.2% for the S&P 500 – beating the benchmark by 8% percentage points per year.
According to their research, companies that can easily pay (low payout ratio) a high dividend (high yield) may be the best dividend stocks to buy for your portfolio.
Dividend Yield and Payout Ratio for 12 Blue Chip Dividend Stocks
Let’s look at data for 10 blue chip / large cap dividend stocks and see how they measure up:
|Blue Chip Dividend Stock||Full Company Name||Current Dividend Yield||Payout Ratio (5Y Average)||Yearly Dividend Growth (5Y)|
|JNJ||Johnson & Johnson||2.6%||64%||7%|
|PG||Procter & Gamble||3.5%||75%||4%|
According to this table, Ford (F), AT&T (T), and Verizon (VZ) all offer relatively high dividend yields with relatively low payout ratios.
Keep in mind, it’s a not a simple rule of “the higher the dividend yield the better.” The authors actually found that while the highest dividend yield stocks did beat the S&P 500, it was the companies in the 80th percentile in terms of dividend yield that performed the best. In other words, a solidly high dividend, but not the highest on the market.
In our Dividend Stock Investor portfolio, we thoroughly analyze dividend payments from several different angles before we buy a stock.
We research a wide range of proven criteria (including payout ratio, dividend yield, and many others) to create a model portfolio of the 25 best dividend stocks to buy now. They’re all stable, successful, high yield dividend stocks with strong top and bottom line growth.