10 Ways for Identifying Top Dividend Stocks
By: Ned Piplovic,
Regardless of any specific portfolio needs, investors must be able to identify the top dividend stocks for their specific investment strategy. Equity analysis became quite complex with the use of computer analysis and the introduction of artificial intelligence modeling. However, even with just a few basic performance metrics, investors can relatively easily narrow their selection of top dividend stocks from tens of thousands of available equities to just a handful of potential investment options.
Before focusing specifically on dividend distribution, investors should narrow the selection of potential top dividend stocks by identifying high quality stocks with a positive long-term horizon outlook. No single indicator or financial metric can identify the absolutely best candidates that could be top dividend stocks. Furthermore, equities that qualify as top dividend stocks for one investor’s specific portfolio strategy, might not fulfill another investor’s distinctive portfolio goals. Therefore, investors should use several of the financial metrics below, as well as additional indicators, to craft a specific set of analytical insights for identifying and selecting top dividend stocks that have the potential to deliver reliable and steadily rising income flow accompanied by moderate asset appreciation.
10 Ways for Identifying Top Dividend Stocks: #1
Stable revenue and revenue growth outlook
Investors should indeed seek investment opportunities that offer high potential for overall returns. However, high returns generally carry a high level of risk, and a lower percentage of high-risk investment deliver returns. While investors can allocate a small fraction of their funds for investing in high-risk investment vehicles, the majority of their portfolio should comprise a sturdy base of securities that offer relatively reliable returns. Therefore, companies that offer stable revenues, and have a good outlook for revenue growth, should be the main focus of investors seeking top dividend stocks.
10 Ways for Identifying Top Dividend Stocks: #2
While certainly important characteristics of equities that can potentially offer substantial and reliable income payouts, stable and rising revenues are just one side of the equation. For overall stability and growth, companies must provide strong profitability. Therefore, in conjunction with steady and rising revenues, equities must minimize their costs. Only after establishing reliable net earnings can equities even consider distributing dividends to their stakeholders.
10 Ways for Identifying Top Dividend Stocks: #3
Dividend Payout Amount
Once an equity has the earnings to support dividend payouts, investors should obviously seek high distribution amounts. High distribution payouts translate to high cash flows, which is important to all, but especially income-focused investors. Equities pay distributions at different frequencies — monthly, quarterly, semi-annually or annually. Therefore, instead of evaluating equities on their dividend payout amounts for each period, investors must make the comparison on a total-annualized-payout basis.
10 Ways for Identifying Top Dividend Stocks: #4
While the absolute dividend payout amount indicates the total dividends distribution, the dividend yield is a better indicator for conveying return on an investment. With a simple ratio of the equity’s total annual dividend distribution amount and the equity’s current share price, the dividend yield is easy to calculate, and is readily available from most sources of information on investment markets.
While higher yields are obviously better, investors must make sure that the high yield stems from rising dividend payouts and not declining share prices. A sudden share price drop will result in a yield spike, which can make the equity appear more desirable than it actually is. Also, a share price spike will push the yield lower.
Therefore, investors must use the dividend yield in conjunction with other metrics to discover the top dividend stocks for their portfolio. The total return over the trailing 12-month period is an easy metric to use in these situations. As long as the one-year total return exceeds the yield, the equity has managed to provide at least minimal asset appreciation to accompany the dividend distributions.
10 Ways for Identifying Top Dividend Stocks: #5
Dividend Payout Ratio
Another simple metric is the Dividend Payout Ratio. This ratio indicates the share of net earnings that an equity distributes as dividend income. Investors generally consider a payout ratio in the 30% to 50% range to be optimal. Dividend payout ratios below 30% indicate that the share of earnings, which is distributed as dividends, is not substantial enough to make the equity desirable to income investors.
Alternatively, equities might not be able to sustain dividend payouts that exceed half of their net income and could end up announcing dividend cuts, or even the outright elimination of dividend distributions. However, certain types of companies, such as real estate investment trusts (REITs), pay higher payout ratios by design. Some equities must distribute at least 90% of their earnings as dividends to achieve and maintain special IRS requirements that exempt them from paying corporate taxes.
10 Ways for Identifying Top Dividend Stocks: #6
Dividend Coverage Ratio
The dividend coverage ratio indicates how many times an equity can pay a dividend from its current net earnings. Calculated as the inverse of the payout ratio, the coverage ratio is derived by dividing the annual earnings per share by the total annual dividend distribution. Alternatively, the coverage ratio also can be calculated by dividing net income — minus dividend payouts to preferred shareholders — by dividends applicable to common shares. Unlike the payout ratio, where lower levels are generally more desirable, investors seek a higher-dividend-coverage ratio.
10 Ways for Identifying Top Dividend Stocks: #7
Dividend Payout Frequency
Considering that most dividend metrics use the total annualized payout amount, some investors might overlook distribution frequency as an important metric to identify top dividend stocks. Even with identical payouts for the full year, monthly dividend payouts can deliver higher total returns over extended periods. However, to achieve these additional returns, investors must reinvest the monthly dividend distributions immediately.
The advantage of reinvesting monthly dividends, versus annual payouts, to enjoy the benefits of the compounding effect, should be obvious. However, even compared to quarterly payouts, reinvested monthly distributions offer additional returns. Assuming a total return rate of just 6% annually, monthly compounding delivers an additional 6.23% in returns, above the returns generated by reinvesting quarterly payouts.
This advantage compounds to an even greater advantage over an extended time horizon. The two-year advantage of compounding monthly dividend payouts is more than 13% and reaches 50% after just six years. Furthermore, compounding reinvested monthly payouts delivers two and five time returns over 10 and 20 years, respectively.
10 Ways for Identifying Top Dividend Stocks: #8
As important as all these previous metrics are, another crucial indicator is rising dividend payouts. As an equity’s share price increases, flat dividend payouts will decrease the dividend yield, which will make that equity less desirable to income investors. Alternatively, rising dividend payouts generally indicate which equities tend to outperform overall markets over the extended horizon. However, share prices tend to grow faster during bull markets, which suppresses the yield. While generally unable to keep pace with share price uptrends, rising dividend payouts can at least minimize the yield deterioration.
10 Ways for Identifying Top Dividend Stocks: #9
Dividend Growth Rate
Not all rising dividends are created equal. Another important indicator is the rate at which dividend payouts increase. For instance, W.P. Carey, Inc. (NYSE:WPC), boosted its dividend payout amount each quarter, for 28 consecutive hikes over the past seven years. In addition to this dividend growth streak, W.P. Carey currently offers a 5%-plus dividend yield and total returns on shareholders’ investment of more than 55% over the last five years. However, despite the long streak of consecutive quarterly dividend hikes and robust returns, which makes WPC a desirable income stock, the company’s small incremental dividend growth translates to an annualized growth rate of just 1.5%.
Alternatively, AbbVie, Inc. (NYSE:ABBV), offers a dividend yield of slightly above 5% just like W.P. Carey currently does. However, AbbVie has boosted its annual dividend payout only nine times over the past seven years. Yet, AbbVie looks like a better choice for income investors as its dividend growth rate is nearly 20% over the same period. AbbVie’s share price did outperform WPC’s asset appreciation by six percentage points (30% versus 24%) over the last five years. However, driven by the faster rising dividend payouts, AbbVie’s total return from dividend income and asset appreciation share price of nearly 90% outpaced WPC’s total return over the same period by 35 percentage points, or nearly two-thirds.
10 Ways for Identifying Top Dividend Stocks: #10
Even if all the metrics listed above look positive, investors should be cautious of companies that hold high levels of debt. While most mid- and large-cap companies can still deliver stable gains over short periods, even with higher-than-average debt levels, excessive leverage over extended periods can lead to diminished earnings growth, lower dividend boosts or even dividend cuts.
The debt-to-equity ratio is a good basic measure of any company’s leverage level. To determine the debt-to-equity ratio, we divide an equity’s total liabilities by its total shareholders’ equity. Because of different portfolio strategies, different risk tolerances and other unique factors, individual investors will have different notions of what constitutes acceptable debt-to-risk ratio.
Ideally, investors would seek equities with debt-to-equity ratios below one. This indicates that the shareholders’ equity exceeds total debt. However, companies that are investing in growth and expansion will generally have more leverage. Therefore, as long as other indicators are positive and the company’s overall fundamentals are sound, it is acceptable for debt to exceed equity. However, most investors looking at a long-term investment horizon should generally avoid companies with debt-to-equity ratios above two.
Investors use many more performance indicators to analyze equities in search of the ones best suited for the individual portfolio strategy and goals. However, the indicators on the list above are adequate enough for even novice investors to identify a few top dividend stocks suitable for building a well-balanced portfolio with steady income distributions, and a good potential for robust capital gains.
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Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.