Experienced investors know that a diversified stock portfolio offers a much better chance of reducing investment risk and potentially increasing the reward. Dividend-paying stocks can help create that diversity.
As with any other part of your portfolio, you are undoubtedly interested in finding the top dividend-paying stocks to add. That means knowing what to look for and what to avoid. For instance, the best dividend-paying stocks aren't necessarily those with the highest yield, since that yield may not prove sustainable and could actually be an indication that the company is about to cut the payment.
There are some tried-and-true questions you can ask as you analyze potential dividend payers. Let's review three questions you should try to answer to find the best dividend stocks.
1. Does the company has a strong balance sheet?
When looking for a dividend-paying stock, it's good to check that the company is financially healthy. This will let you know if it is set up to survive difficult times and that it can continue to pay out a dividend even when the company faces headwinds.
This information is found on a company's balance sheet, with cash and debt as two key figures. One company well equipped to finance its dividend payout is Microsoft (NASDAQ: MSFT). Microsoft one of only two U.S. companies carrying the highest possible credit rating from the rating agencies. At the end of 2020, it had $132 billion in cash and short-term investments at its disposal and about $60.5 billion in debt. Microsoft's strong balance sheet has allowed it to consistently raise its dividend yearly since it started paying one in 2004.
Alternatively, AT&T (NYSE: T) had $9.7 billion in available cash and short-term investments and over $157 billion of debt on its books. That large debt load came from several acquisitions in recent years as well as investments related to upgrading its telecom network. AT&T still generates plenty of cash each year to finance its operations, but it's notable that the board of directors has not increased the dividend yet this year (which it normally does by now), and only kept the rate steady.
So the balance sheet matters. Once you are satisfied that the company has its financial house in order, you can dig deeper into the company to determine its dividend-paying ability.
2. Is there consistency (and growth) in the dividend payouts?
When a company not only pays dividends for a long time but also raises them regularly, it demonstrates a commitment on the part of management to rewarding shareholders. If an S&P 500 company does this long enough, it can earn a special designation as a Dividend Aristocrat, which is a member of the index that has increased payments on an annual basis for at least 25 straight years.
Companies that have raised their dividend payouts annually for at least 50 years get the even more rare designation as Dividend Kings. This very exclusive list includes companies like Coca-Cola and Colgate-Palmolive (NYSE: CL).
A company that consistently increases dividends through all kinds of economic environments, including severe economic downturns and events like the coronavirus pandemic, demonstrates that it has a solid, growing company. Colgate-Palmolive has been making dividend payments to its shareholders in some form since 1895. The board of directors recently announced it would hike the quarterly per-share payments by a penny to $0.45, bringing its consecutive streak of dividend growth to 58 years.
But dividend consistency in the past isn't always a guarantee that things will continue that way. For instance, there were many otherwise solid companies that were forced to reduce or suspend their dividends in 2020 as a response to the pandemic. Walt Disney is a strong company with a history of paying out and raising dividends, but it had to suspend them this year because the pandemic disrupted its businesses so severely.
Hence, checking the balance history and payment history is a good first step, but you should go further to ensure a company will continue paying dividends.
3. Is there enough free cash flow to finance the dividends?
Companies doing well can either retain excess earnings to finance further growth in their operations, save the funds for some future need, or pay the excess earnings out in some form (including as dividends). Dividend-paying companies with weak growth or declining bottom lines clearly face a challenge in keeping up with dividend payments.
A relatively reliable measure of a company's ability to maintain its dividend is to calculate its payout ratio, which is the percentage of its net earnings (basically the cash it has left over after everything is paid for) that goes toward dividends. This percentage often fluctuates in the short term, but for a solid dividend-paying company, you would like to see it remain stable over time.
In the case of Colgate-Palmolive, its payout ratio was 56% last year, which is considered a manageable ratio. Over the last few years, it has stayed at that level, suggesting stability. Ideally, higher earnings should lead to increased free cash flow. Last year, Colgate-Palmolive generated $3.3 billion in net earnings, leaving plenty of free cash to cover the $1.7 billion of dividends it paid out.
A lower payout ratio provides a bigger cushion for the fluctuations that occur from quarter to quarter, so a company can continue paying dividends if it hits a temporary rough patch. Obviously, a payout ratio above 100% is unsustainable, but those exceeding 70% could present an issue down the road. It is important to check the trend to see if it has been moving up markedly over the last several years. That would suggest the company might be forced to cut the dividend or suspend it entirely, absent an earnings improvement.
Dividends are a nice way to generate regular income. However, there are some simple things you look at beforehand to ensure that you keep enjoying the payments.
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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Lawrence Rothman, CFA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft and Walt Disney. The Motley Fool has a disclosure policy.