Lesson 26 of 43 (Dividend Investing): A Step-by-Step Guide to Picking the Best Dividend Stocks

  • Dividend yield is a powerful metric to measure how much you’d make in dividends each year compared to how much you’d have to invest.
  • Historically, dividends have made up roughly 40% of the stock market’s total returns.
  • Stocks with high dividend yields (but NOT the highest yields) perform well over time.
  • We walk through a step-by-step guide to finding the best dividend stocks, including screenshots and direct links to a stock screener that’s pre-filtered for high-potential dividend stocks.

IIn this lesson we’re going to dig into one of the most steady and profitable strategies on the stock market: dividend investing. 

Following our familiar format, let’s walk through four important concepts:

  1. What are dividend stocks?
  2. What should you know about investing in dividend stocks?
  3. Which dividend stocks perform best?
  4. How do you find the best dividend stocks to buy? (A step-by-step guide)

What Are Dividend Stocks?

A dividend stock is any company that pays a regular dividend to its shareholders.

Companies that pay dividends are returning some of their profits to shareholders in the form of a regular cash payment.

Beyond that, we’d narrow the definition even further to focus on companies with a dividend yield of at least 1%. Anything less than 1% is probably not worth owning (from a dividend income perspective).

What Should You Know About Investing in Dividend Stocks?

Many companies (literally thousands) pay dividends to their shareholders on a regular basis.

Companies that pay dividends have decided they don’t have a high-growth area in their business to invest all their cash, so they’ll return some of it to shareholders.

These slow-growing, more mature companies tend to pay dividends while fast-growing companies tend to reinvest their cash and profits into growing their business.

Dividends are usually paid out quarterly and over a full year they typically add up to somewhere between 1% – 6% of the amount you would pay to buy a single share of stock.

As a reminder, the ratio of the amount of the dividend paid in a year compared to the current price of the share is called the “dividend yield.”

Here’s the official dividend yield formula:

The dividend yield is the most important metric to understand as it measures how much you’ll make in dividends each year vs. how much you’ll have to pay to buy a share.

Before we dive into the details of which dividend stocks perform best, let’s do a quick recap of two early lessons on dividend stocks:

Here are the major takeaways from both lessons:

  1. Dividends are regular cash payments from a company to its shareholders
  2. Dividends are usually paid out quarterly (but not always, they can range from a single one-time payment up to regular monthly payments)
  3. Dividend payments usually remain fairly steady or trend slowly upwards over time (but they can also sometimes decline if a company is struggling financially)
  4. Often slower-growth companies pay dividends and faster-growth companies do not (there are exceptions)
  5. Dividends (or high dividends) don’t automatically make a stock a “good” investment or better than other stocks
  6. Dividend yield is a powerful metric to measure how much you’d make in dividends each year compared to how much you’d have to invest
  7. Most dividend yields range from 1% up to 6%, but there are some companies that can go much higher
  8. Historically, dividends have made up roughly 40% of the stock market’s total returns.
    Reinvesting dividends adds tremendous compounding power to your investing.

One thing to note, there are some companies that pay their dividends on a monthly basis, but this is quite rare. Some investors (especially retirees) flock to these stocks because the monthly dividend can feel almost like a monthly paycheck.

Which Dividend Stocks Perform Best?

When it comes to finding the best dividends stocks on the market, there are three important characteristics you should focus on.

These three metrics are based on our extensive research into how to find the dividend stocks that will earn you the most money over time. 

  1. Strong dividend yield
  2. Low payout ratio
  3. Steady dividend growth

Let’s look at each more closely to understand why it’s important.

Strong Dividend Yield

In our lesson covering growth stocks we discussed how some growth investors look for companies with the absolute highest sales growth possible, thinking that will find them the best growth stocks.

This is usually a big mistake.

There’s a similar lesson in dividend stocks: The companies with the absolute highest dividend yields don’t usually offer the best returns.

First, let’s look at this analysis from Hartford Funds, which compares the percentage of time dividend stocks with different yields outperformed the S&P 500 from 1929 – 2017. 

They’ve divided all dividend stocks into five quintiles based on their yield, with the highest yielding stocks in Quintile 1 and the lowest yielding stocks in Quintile 5.

As you can see, the highest yielding stocks in the 1st Quintile outperformed the S&P 500 roughly 78% of the time – pretty good!

But the 2nd Quintile, which has LOWER yields than 1st Quintile, outperformed the S&P 500 roughly 89% of the time – incredible!

Why is this? Why do slightly lower yielding dividend stocks outperform the highest yielding dividend stocks?

Research suggests it’s because they have a better payout ratio.

Low 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.

If we compare the payout ratio for the 1st Quintile vs the 2nd Quintile, we see a dramatic difference.

On average, companies in the 1st Quintile are paying out 71% of their earnings in the form of dividends. This means they’re only left with 29% of their income to reinvest into the business, pay down debt, buy back shares, etc.

On the other hand, 2nd Quintile stocks are paying out an average of just 41% of their earnings in the form of dividends, leaving them with 59% to allocate elsewhere.

Research suggests companies with high dividend yields AND high payout ratios are paying out more than they can afford. This inevitably leads to financial strain or a dividend cut, both of which will be punished harshly by Wall Street.

On the other hand, companies with a high dividend yield AND low payout ratio are paying out a lot of money in dividends, but they can afford it because they’re making a lot of money from their core business. This is a sign of both long-term dividend sustainability and operating strength.

Researchers at Credit Suisse found that stocks that combine high dividend yield and low payout ratio tend to dramatically outperform other dividend stocks.

Put simply, these are companies that can easily afford to pay a high 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.

While dividend yield and payout ratio are powerful predictors of the best dividend stocks, there’s one more element to consider when researching dividend-paying companies.

Steady Dividend Growth

Research shows that companies that are steadily growing (or initiating for the first time) their dividend tend to perform well over time.

Let’s look at this fascinating analysis from Hartford Funds.

Here they compare S&P 500 companies that are growing, cutting, or keeping their dividend flat to the S&P 500.

As you can see, companies that are growing their dividends have performed the best, whereas dividend non-payers and cutters have performed the worst.

So, in addition to dividend yield and payout ratio, it’s critical to analyze whether a company has a history of growing its dividend.

And make sure to avoid companies that have dividend cuts in their recently past.

Now that we have our three key dividend metrics, let’s tie it all together into a powerful stock screen.

Based on our insights above and extensive research, we would focus on finding dividend stocks that meet these five criteria:

  1. Strong dividend yield
  2. Low payout ratio
  3. Steady dividend growth
  4. Profitable and growing
  5. Not overvalued

Let’s take these criteria and use the FinViz stock screener to find some strong dividend stock candidates.

How Do You Find the Best Dividend Stocks to Buy? (A Step-By-Step Guide)

Below are the criteria we’d suggest for finding good dividend stocks.

Please keep in mind, we’re not suggesting the screening criteria you see below are the absolute perfect criteria. Instead, we think these criteria will give you a VERY strong starting point to refine the parameters to your personal liking and begin your own careful research.

We purposefully left the criteria just a little loose (letting more stocks through) so that you could review the results and tighten the rules where YOU think best.

When we first designed this screen, it reduced an unfiltered list of 7,500 stocks down to just 45 highly attractive candidates.

Keep in mind, your numbers will likely differ from ours in this example because stock data changes every single day.

Here is the screen we’d suggest using to find highly attractive steady dividend stocks:

Notice the fields we’ve adjusted are highlighted in yellow.

You can click here to see the screener and full results in FinViz.

Notice that we have selected:

  • Mid-cap companies or larger (adjust this based on your preferences)
  • Positive sales and earnings growth over the last 5 years
  • Positive net profit margins
  • Dividend yields over 3% (to find strong dividend income)
  • Payout ratios under 50% (to find sustainable dividends)
  • Price / free cash flow under 50 (to avoid overvalued companies)

The last criteria is dividend growth, which unfortunately is not offered in the FinViz screener.

Instead, we’d suggest you tweak your criteria on FinViz until you narrow your results to a solid short list of high-quality dividend stocks for your further research.

Then, take these candidates and check them against Dividend.com, which is a great resource for analyzing dividend companies (we have no affiliation with Dividend.com). 

For example, Verizon (VZ) was one of the companies that came up in our screen results as profitable, growing, undervalued, and paying a healthy, sustainable dividend.

(Please check the FinViz results yourself to see if Verizon is still considered a top dividend stock.)

Let’s take a closer look at Verizon’s dividend growth history and payout history on Dividend.com

Here’s their dividend growth history (click here):

And here’s their payout history table (click here), which you can expand to look further back.

In both cases, you can clearly see that Verizon has been steadily increasing its dividend payments for the last 12 years.

This suggest Verizon stock offers a strong dividend profile: a high dividend yield, low payout ratio, and a history of dividend growth.

Lesson Summary (Dividend Investing): A Step-by-Step Guide to Picking the Best Dividend Stocks

We covered a lot in today’s lesson on dividend stocks, starting with a quick review of our earlier dividend lessons and ending with a range of metrics and two tools you can use to find the best dividend stocks.

Let’s summarize what we learned here:

  1. Dividends are regular cash payments from a company to its shareholders
  2. Dividends are usually paid out quarterly (but not always, they can range from a single one-time payment up to regular monthly payments)
  3. Dividend payments usually remain fairly steady or trend slowly upwards over time (but they can also sometimes decline if a company is struggling financially)
  4. Often slower-growth companies pay dividends and faster-growth companies do not (there are exceptions)
  5. Dividends (or high dividends) don’t automatically make a stock a “good” investment or better than other stocks
  6. Dividend yield is a powerful metric to measure how much you’d make in dividends each year compared to how much you’d have to invest
  7. Most dividend yields range from 1% up to 6%, but there are some companies that can go much higher
  8. Historically, dividends have made up roughly 40% of the stock market’s total returns.
  9. Reinvesting dividends adds tremendous compounding power to your investing.
  10. Stocks with high dividend yields (but NOT the highest yields) perform well over time.
  11. Buying stocks with high dividend yields AND low payout ratios is an extremely powerful dividend strategy.
  12. In addition, stocks that are growing their dividends show they are financially healthy and committed to returning profits to shareholders.
  13. You can find the pre-filtered dividend screen here.
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Author

Todd Lincoln

Author

Passionate stock market investor with deep experience trading small cap, dividend, and growth stocks.

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