How to Choose the Best Dividend Stocks
By: Jonathan Wolfgram,
by Ned Piplovic
While the variety of investment options that are currently available offer investors choices that will enable them to meet different portfolio goals, selecting the best dividend stocks can deliver steady total returns that build wealth with relatively limited risk and volatility.
However, while wealth generation and wealth protection are universal portfolio goals, the specific goals, targets and time horizons of individual portfolios vary. Therefore, the determination of what constitutes the best dividend stocks will be different for different investors and even for the same investor at different times.
Old maxims like “buy low and sell high” encompass the general sentiment that investors share. However, building a portfolio that includes the best equities to meet a multitude of specific investment goals requires knowledge, expertise and commitment in order to execute the chosen investment strategy. Even with investing expertise and experience, choosing the best dividend stocks may seem like a difficult task. However, armed with some basic understanding of the inner workings of financial markets, most individual investors should be able to select the best dividend stocks for their particular portfolio needs and then enjoy the results of their equity selection.
Dividends or No Dividends
There are varying opinions on all investment topics. For instance, investors even disagree whether dividends have any impact on a stock’s performance. One segment of investors and financial experts question the validity of distributing corporate earnings to shareholders. These investors see the dividend distributions as wasted opportunities. The Modigliani-Miller Theorem—developed by economists Franco Modigliani and Merton Miller in the 1950s—claims that dividend distributions have no effect on the level of long-term capital gains in perfect market conditions.
According to Modigliani and Miller, a company can deliver additional capital gains to its shareholders by financing new investment opportunities with any extra corporate earnings. Therefore, the Modigliani-Miller Theorem claims that companies should employ dividend income distributions only as a last resort and only if there are no alternative investment opportunities that could generate additional returns.
While the Modigliani-Miller Theorem certainly offers a compelling argument, the argument generally works only under perfect market conditions. These conditions do not exist, or at least, do not exist over extended periods. Additionally, while not offering a definite causal relationship between dividend payouts and outsized long-term returns, historically back-tested data indicates that dividend-paying companies outperform non-dividend equities over extended periods of time.
A 2019 study conducted by Hartford Funds compared the total returns of the S&P 500 stocks between 1960 and 2018. When considering purely asset appreciation, the S&P 500 Index advanced more than 43-fold over the selected time frame, which was a significant return on investment. However, just reinvesting all dividends immediately after their distribution increased the total return over the same period from 43-fold to 246-fold. As illustrated in the graph from the Hartford Funds study below, reinvested dividends generated $5.70 in additional returns for every $1 of straight asset appreciation.
Graph Source: The Power of Dividends, Hartford Funds, January 2019
A different study that was conducted by Ned Davis Research has indicated that dividends can have an even better potential impact on long-term returns. After classifying all S&P 500 equities into five groups based on their dividend status, this study compared each group’s total returns since 1972 to the returns of the equal-weighted S&P 500 Index. While equities that paid no dividends tripled in value, these equities achieved less than 12% of the overall S&P 500 Index’s gains. Furthermore, equities that cut or eliminated their dividend payouts entirely performed even worse. These equities advanced only 70%. This represents less than 2.5% of the total gains for the overall index, which advanced 27-fold during the tested time frame.
However, dividend-paying equities performed 90% better than the weighted index and delivered 52-fold gains. Lastly, equities that either initiated dividend payouts or maintained rising dividend payouts achieved a 75-fold return over the same period. These gains are nearly triple the average index gains and almost 2,400% better than equities that did not pay any dividends.
Dividend Types and Other Considerations
Dividends basically are distributions of earnings—and sometimes assets—to the company’s stakeholders. However, dividends can come in different forms. The most basic classification would be into cash and in-kind—non-cash—dividends. Of these two types, cash dividends are significantly more common. While some types of in-kind dividends certainly have their advantages, the fact that it is easy to account for and manage dividends makes equities with cash income payouts the best dividend stocks for most investors.
However, companies occasionally will distribute a portion of their earnings as stock dividends. These take the form of company shares that are equivalent to the value of the declared dividends that were distributed to the shareholders. The main advantage of stock dividends for investors is that the Internal Revenue Service (IRS) treats stock dividends as stock splits. Therefore, unlike cash income payouts, stock dividends do not carry any income tax liability for the year in which they are distributed. The tax liability occurs only when the investors sell their shares. However, even then, they are taxed at capital gains rates, which are generally lower than the earned income tax rates that are applicable to all cash dividend distributions—except for qualified dividends, but more on those later.
Stock dividends also offer liquidity advantages to the equity that is making a distribution. Since stock dividends require no cash distributions, an equity can issue additional shares as dividend distributions. When a company finds itself short of cash, the company might resort to issuing additional shares and distributing those new shares to its shareholders instead of initiating cash payouts.
Other types of in-kind dividends—the bonds of the company that is distributing dividends, bonds of a different corporation, government bonds, accounts receivables, promissory notes, etc.—do exist, but cash dividends offer the best combination of liquidity and transaction simplicity. Therefore, equities distributing cash income payouts will generally be the best dividend stocks for most income-seeking investors.
To choose the best dividend stocks for their own portfolio, investors also must consider the dividend payout frequency. Generally, equities can choose any dividend distribution frequency they desire. However, most companies chose a dividend distribution schedule that aligns with their annual business cycle or the periodic release of their financial results. Therefore, most equities in North and South America distribute their dividends on a quarterly basis. Certain types of business entities also distribute dividends monthly.
Unlike publicly-traded companies in North America that generally report their financial results each quarter, companies in Europe and Japan have less frequent reporting requirements. Therefore, these companies often distribute their dividend income payouts semi-annually or even annually.
The dividend distribution frequency might not have any impact for investors with long-term wealth creation goals in mind. This will especially be the case for investors who have other sources of income—such as a job—and invest primarily for retirement. Semi-annual and annual distributions suffice in these cases. However, investors without alternative income sources, or investors who are on a fixed income—such as retirees—might require more frequent dividend income distributions to cover their ongoing living costs and expenses. As even quarterly distributions might be too far apart, the equities that distribute their dividends each month might be the best dividend stocks for these investors.
How to Identify the Best Dividend Stocks
Regardless of any specific portfolio needs, investors must be able to identify the best dividend stocks for their specific investment strategy. While the analysis can get complex, investors have few basic metrics at their disposal in addition to the dividend payout amount to at least narrow the field from thousands of potential options to just a few candidates.
The first and most frequently quoted measure of dividend valuation is the dividend yield, which is the ratio of the total annual dividend payouts and the equity’s current share price. The actual total dividend distributions over the past year give us the trailing dividend yield. However, using the annualized dividend amount from the most recent period returns the forward dividend yield.
Higher yields are obviously better. However, because the dividend yield is inversely related to the equity’s share price, it can be a very unreliable indicator on its own. A sudden share price drop will push the dividend yield higher and give a false impression of a positive performance. Alternatively, a yield decline driven by a share price surge should not eliminate a stock from consideration.
Another basic dividend measure is the Dividend Payout Ratio. This ratio indicates the share of the equity’s net earnings that are distributed as dividend income distributions. This ratio can be calculated from the total figures that are available in corporate financial statements or by simply dividing the total annualized dividend paid per share by the company’s earnings per share (EPS).
A general guideline for a substantial and sustainable payout ratio is from 30% to 50%. Dividend payouts that make up at least 30% of a company’s net income are substantial enough to attract income-seeking investors. Alternatively, dividend payouts of less than half a company’s net income are not too high and will not threaten future payouts by starving the company of cash for continued operations. Certain types of equities have higher payout ratios by design. For instance, real estate investment trusts (REITs) must, by law, distribute at least 90% of their earnings as dividends in order to maintain their preferred tax status and avoid paying corporate taxes.
While dividend yield and the dividend payout ratio are the two most prominent metrics, dividend growth is probably a much better indicator of an equity’s performance and advancement over and extended time horizon. As mentioned earlier in the Ned Davis Research study, the group of equities that performed best were the equities that maintained a record of rising dividends.
We can compare dividend growth over the short term, such as between any two periods of time, as a trend over several periods or as a standard compounded growth rate (CAGR) for any time frame. The most significant aspect of this metric is that it can gauge whether the dividend growth is keeping pace with asset appreciation. Because share prices generally appreciate, dividend distributions that stagnate and that do not grow lead to diminished returns over extended periods. This, in turn, can jeopardize any equity’s status as one of the best dividend stocks.
As mentioned above, stock dividends enjoy the advantage of deferred taxation at the lower, capital gains tax rate when compared to cash dividends. While taxation cannot be deferred for cash dividends, some cash payouts can enjoy the same lower tax rates under certain conditions.
Reducing one’s tax liability is certainly an important aspect of estate and investment portfolio planning. However, taxation will rarely be the driving factor in any investor’s decision process to identify the best dividend stocks. However, as a final tiebreaker between two investment choices, saving a little on taxes can occasionally have a significant impact on the final size of the portfolio after compounding for many years.
Generally, only American companies can issue so-called qualified dividends. These enjoy taxation at the same capital gains rate as stocks and stock dividends. The IRS has a strict and detailed set of rules and requirements all dividends have to meet to attain this status.
Regardless of their qualification status, dividend distributions are subject to double—and sometimes even triple—taxation. While this is not optimal, some companies can offset some of that multiple taxation burden through a dividends received deduction (DRD). The dividends received deduction is a specific tax write-off under the U.S. federal tax code which allows certain corporations to deduct, from their taxable income, a portion or all received dividends from another business entity in which the corporation has an ownership stake. Therefore, seeking out the dividends that are paid by corporations which are taking advantage of the DRD should be part of the methodology that every investor uses to identify the best dividend stocks.
With many aspects to consider, which types of equities do ultimately qualify as the best dividend stocks? Based on the information offered above, equities that offer high-yield and steadily rising qualified cash dividends with a 30% to 50% payout ratio and rising share prices should be on the top of every investor’s list of the best dividend stocks. Unfortunately, very rarely—if ever—will a single equity offer all these characteristics at the same time.
Therefore, just like investors diversify their portfolio across asset classes and industry sectors, every investor’s best dividend stocks will be a diverse group of equities that meet that specific portfolio’s long-term strategic goals. This article offers some basics to help identify the types of equities that have the potential to become the best dividend stocks over extended time horizons.
However, these are just the basics. The complexities of the stock market also necessitate more in-depth analysis. For further information and additional articles on dividend investing and dividend-paying equity recommendations, go to www.DividendInvestor.com. Additionally, you can start your own research for dividend-paying stocks that fit your investment portfolio strategy by taking a quick video tour of our custom tools suite.
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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.