Here's How to Find the Best Dividend Stocks

By Leo Sun Markets Fool.com

Dividend investors often prioritize a stock's yield above all other factors. While a stock's yield is certainly important, it's also important to examine five other key factors -- payout ratios, earnings growth, free cash flow growth, valuations, and historical dividend hikes.

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Payout ratios

A stock's payout ratio is the percentage of a company's earnings which are allocated to dividend payments. The lower this percentage is, the more room a company has to grow its dividend. If the payout ratio remains above 100% for several quarters, the dividend is likely unsustainable.

For example, hard drive maker Seagate (NASDAQ: STX) has a forward dividend yield of 6.4%, but it also has a whopping payout ratio of 200%. Its bigger rival, Western Digital (NASDAQ: WDC), pays a lower forward yield of 3%, but has a much more sustainable payout ratio of 56%. Income investors who only chase yield would probably buy Seagate instead of Western Digital, but they could be disappointed by a big dividend cut in the future.

Earnings growth

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Investors should also avoid income stocks with declining earnings. For example, camera maker Canon (NYSE: CAJ) pays a forward yield of 4.7% and has a payout ratio of 86%. However, its earnings are also expected to fall 25% this year and another 5% next year dueto the commoditization of the camera market.

Those declines will inflate Canon's payout ratio and increase the likelihood of a dividend cut. Moreover, Canon's poor earnings growth is already reflected in the stock's 34% decline over the past five years. Therefore, investing in a declining stock with sliding earnings for a higher yield isn't a sound strategy.

Free cash flow growth

Earnings-based payout ratios can be distorted by buybacks, follow-on offerings, or all sorts of bottom line adjustments. As a result, some payout ratios don't accurately reflect the sustainability of certain dividends.

That's why investors should also check a company's free cash flow (FCF), which is a company's operating cash flow minus its capital expenditures. By comparing a company's total dividend payments over the past year to its FCF, we can calculate the FCF payout ratio -- which more accurately reflects a dividend's sustainability.

If we check Seagate again, we'll notice that it only paid out 61% of its FCF as dividends over the past 12 months. This means that Seagate can keep supporting its dividend for now, although the payments exceed its per-share profits every quarter. Companies sometimes do this if they believe that reducing the dividend would cause a big sell-off. But if a company's earnings and FCF payout ratios both exceed 100%, the dividend will likely be cut.

Valuations

The low interest rate environment has made dividend stalwarts more attractive than bonds over the past few years. But that will change as interest rates rise, boosting the yields on high-grade bonds to levels which match those of income-generating stocks. Since bonds are fixed income investments with guaranteed returns, they will become the preferred vehicle of wealth preservation for income investors.

As a result, dividend stocks which have rallied to historically high prices and valuations could be aggressively sold off as rates rise. Tobacco giant Altria (NYSE: MO), for example, currently trades at 25 times earnings compared to the industry average of 21 for big tobacco companies. Its yield of 3.5%, while solid, also hovers near a historical low:

Source:YCharts

This means that Altria, and other dividend stalwarts with high valuations and low yields, will be hit hard by interest rate hikes next year. Investors should avoid those types of dividend stocks and stick with ones thattrade at discounts to their industry peers.

Dividend hikes

Lastly, some stocks have high yields but don't raise their dividends annually. A company doesn't need to be a "dividend aristocrat" that has raised its payout for over 25 years, but a strong record of dividend hikes indicates that it's dedicated to rewarding long-term, buy-and-hold investors with a consistent cut of its profits.

The key takeaway

I personally own a lot of dividend stocks, and I've made plenty of mistakes chasing high-yield stocks in the past. But I found that by looking beyond yield, it was easier to find safer income stocks with sustainable yields, consistent dividend hikes, low valuations, and decent profit growth. Therefore, income investors should run their potential dividend plays through these tests to see if they're worthy long-term buys.

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Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.