Here's How to Find the Best Dividend Stocks

By Rich Smith Markets Fool.com

Finding a great dividend stock is about more than just finding the stock with the biggest yield. Sure, when dividends are your focus, the dividend yield is the most important number. But there are a number of other factors you also need to consider.

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For example, you might find a stock paying a great dividend today. But if the company isn't generating the free cash flow necessary to fund its dividend, it might be forced to cut its dividend tomorrow-- in which case you'll be in the unfortunate position of owning a not-so-great dividend stock, and probably one whose stock price is plummeting, as other investors flee the falling dividend.

Of course, if falling dividends are bad, it makes sense that growing dividends must be good? In which case, you might also want to look into a dividend stock's payout ratio. This metric expresses as a percentage the dividends a company pays relative to the earnings it uses to pay them. A stock with a 100% payout ratio, for example, may be "maxed out" and financially incapable of growing its dividend. Conversely, a dividend stock with a payout ratio of only 50% might have ample room to grow its dividend over time.

Analyst projections for rising earnings are another indicator that over time, a stock that pays a good dividend today might pay an even better dividend tomorrow.

A GREAT DIVIDEND MAKES EVERYONE SMILE. IMAGE SOURCE: GETTY IMAGES.

With these considerations in mind, I've taken the liberty of drawing up a screen on free stock screening websitefinviz.com). I've instructed it to search for:

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  • Reasonably large, established companies, with a $2 billion in market cap and up.
  • A respectable dividend (at least 3%).
  • Companies that devote less than 70% of annual profits to dividend payouts.
  • Positive free cash flow.
  • Companies projected to continue earning, and growing earnings, over the next five years.

The following are three stocks that appear to fit the bill. Go ahead -- read on and give them a look, and see if you agree.

Boeing

You probably know that Boeing (NYSE: BA) makes great airplanes, but did you know that it also pays a great dividend? At 3.1%, Boeing's dividend yield is almost half again as big as the average payout of S&P 500 companies.Yet at the same time, Boeing's P/E ratio of 21.6 is nearly four points cheaper than the average valuation of 25.4 times earnings on the S&P.

What's more, Boeing's $5.68-per-share annual dividend represents only 58% of reported net income -- the aforementioned payout ratio -- which lends some assurance that its dividend is "safe." Adding further assurance is the fact that, according to data from S&P Global Market Intelligence, Boeing generated $9 billion in free cash flow over the past year. That's more than enough to cover Boeing's dividend obligations -- it's almost twice Boeing's reported net profits.

Furthermore, analysts who follow the company expect to see Boeing grow its profits at about 16% annually over the next five years -- giving the company plenty of opportunity to continue growing its dividend. That Boeing has booked orders for more than 5,700 aircraft that still remain to be built and delivered, with more orders coming in every day, supports analysts' belief that Boeing will be growing its profits, and its dividends, for years to come.

Vale S.A.

Producing iron ore and pellets, coal, and even precious metals, Vale S.A. (NYSE: VALE) seems like a name that more investors should know. But being based in Brazil, it's a name that may fly too low to have appeared on all investors' radar.

That would be a shame, though, because Vale stock has a lot to recommend it to value investors and dividend investors alike. (It's not just me saying that, either. Last week, investment banker BMO highlighted Vale as a stock with 22% upside potential.)In terms of valuation, Vale stock sells for a lowly 9.3 P/E ratio. (Some investors may worry that the company is being sued by Brazilian authorities over its role in the 2015 Samarco mine disaster, but with the lawsuit now suspended, and a settlement being worked out, that risk may not be as big as once feared).

And as for the dividend, it yields a tidy 4%, making Vale a more generous dividend payer than Boeing, despite earning a bit less than Boeing does ($4.7 billion annually) and also generating less free cash flow ($5.6 billion). Still, there's plenty of profit, and cash, to finance the generous dividend payout.

With its annual dividend payout of $0.34 per share, and diluted earnings per share of $0.91, I calculate the dividend payout ratio at about 37%, which leaves plenty of room for expanding the dividend as well. With analysts on average estimating that Vale will grow not much slower than Boeing -- 15% annually over the next five years -- I see every likelihood that dividends will, in fact, grow over time.

Valero

And I think we'll wrap up with yet another story of respectable growth wrapped in a value stock package: oil refiner Valero (NYSE: VLO).

Valero just wrapped up its Q1 earnings last month, reporting rising profit margin and better-than-expected earnings. With those numbers in the bag, Valero stock now sells for a very attractive P/E ratio of just 13.8 -- and because Valero, like the other stocks on this list, generates more cash from its business than it reports as net income, and an even better price-to-free cash flow ratio of just 7.6.

But Valero is more than just another pretty value stock. It also sports the best dividend yield on today's list, weighing in at 4.3%. Even so, its annual dividend payments of $2.80 per share represent just 55% of net profit.

What's Valero's incentive to grow those profits? That depends, as the company may prove cautious about boosting payments in the face of a topsy-turvy oil market that's seen recent price spikes in response to oil production cutbacks by Russia and OPEC. Still, with most analysts agreeing Valero has the ability to grow its profits at a respectable 13% annual rate over the next five years, I see potential for this dividend, too, to grow.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of Vale S.A. The Motley Fool has a disclosure policy.