How to Choose Dividend Stocks

People look at stocks displayed at the New York Stock Exchange at Wall Street on Feb. 24, 2022 in New York. (Angela Weiss/AFP via Getty Images)

By Kim Clark From Kiplinger’s Personal Finance

Whatever kind of dividend you’re looking for—high yield, high growth or the holy grail of both—professional dividend investors say to consider these three factors.

Dividend Yield

Yields vary by sector and industry. Real estate, energy and utilities companies generally pay at least 3 percent. Some niches in declining industries, such as tobacco companies, pay out high dividends because they no longer invest much in growth and focus on generating cash for shareholders. Technology and communications firms, as well as companies that provide nonessential consumer goods or services, have low average yields—currently less than 1 percent, according to S&P Dow Jones Indices.

Just try not to be dazzled by the highest yields. Generally speaking, a super-high yield, or a sudden jump, can signal a troubled company whose stock price is sinking, or it may simply indicate an unsustainably high payout.

Payout Ratio

One way to tell whether a company can afford to keep paying—and potentially raise—its dividend is to look at the percentage of earnings it pays out as dividends, known as the payout ratio, says Stephen Horan, an associate professor of finance at the University of North Carolina Wilmington.

Although the average payout ratio for the S&P 500 was recently about 36 percent, this, too, varies by industry. Technology companies pay out, on average, only about 21 percent of their profits, retaining the rest for internal investments, such as research. Energy companies have recently been paying about 50 percent of their profits to investors. Just as with dividend yields, a high number is a warning sign, Horan says.

But it’s important to look at this measure over time because some companies can have a high ratio during one bad year but then recover. Consistently paying out more than about 75 percent leaves little buffer for potential trouble, Horan says.

Dividend investors should also pay close attention to a company’s free cash flow (the cash left over after expenditures to operate, maintain and expand the business) because that’s where dividends come from.

History

A commitment to a steadily rising dividend is a sign of capital discipline, says Mike Barclay, senior portfolio manager of the Columbia Dividend Income Fund. Fledgling companies husband their cash to invest in expanding their business. Less-mature companies with a surplus of cash tend to spend it on buying back company stock (or, sometimes, ill-advised investments). “Stock buybacks are like dating,” he says, because companies can stop them at any time without consequence. “Dividends are like marriage” because companies that cut them are typically punished harshly by investors.

©2024 The Kiplinger Washington Editors, Inc. Distributed by Tribune Content Agency, LLC.

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