What Separates a Good Dividend From a Great Dividend

The best dividend stocks pay a respectable yield consistently over time. To do that, a stock must meet three criteria. This article breaks down those criteria and teaches you the fundamentals of evaluating great dividend stocks on your own.

1. StabilityBefore anything else, a company must be stable to reliably pay a dividend quarter after quarter. But what, exactly, does stable mean?

It means the company is established with a strong brand and healthy market share. The company has been around for several economic cycles and has a track record of performance through the good times and the bad.

For example, look at the list of companies known as the "Dividend Aristocrats." These companies are defined as S&P 500 companies that have increased their dividend payouts for at least 25 consecutive years. A great majority of these companies are easily recognizable, household names, and the remainder are common names for those who work in their given industry.

These companies are stalwarts. They are the workhorses of their industry. They have wide moats that protect their business.

Stability also means steady, but not explosive, growth. Growth is a good thing, yes, but excessively fast growth can cause the company to need cash that would otherwise be available as a dividend (more on cash and capital in just a minute).

For example, if Wal-Mart Stores were to double sales next year, the company would also have to massively increase the inventory in its stores and warehouses. Buying all that new inventory would require a huge amount of money, cash that could have been given back to shareholders as a dividend.

2. Sufficient capitalWhen a company pays a dividend, it reduces the cash, which is obviously an asset, held on its balance sheet. To make the accounting balance, the equity side of the balance sheet must shrink by the same amount. Consequently, a company can only afford to pay a dividend if it has enough equity/capital to do so.

During the financial crisis, the banking industry was hit exceptionally hard. A huge number of banks were forced to cut their dividends. Why?

Because the banks had huge debt levels and relatively tiny capital levels. With the weight of the financial crisis bearing down on them, the banks couldn't afford to lose any capital. That meant the dividend had to go. It's no coincidence that you don't see any banks on that list of Dividend Aristocrats.

How much capital is enough capital? That answer varies by industry. Highly regulated industries such as banking, insurance, or utilities will have established guidelines defining precise levels of required capital. Other industries are more difficult to gauge.

My advice in those cases is to compare the debt-to-equity ratioof the stock you're considering against three to five of its closest competitors. That should give you a good idea of the industry standard and how your potential investment compares.

3. Cash is kingYou're buying a dividend stock because you want a cash dividend. To pay you in cash, the company must have enough cash on hand to pay the dividend check and maintain the cash needed to operate the business.

The best dividend stocks will have plenty of cash flow to do just that. Weaker payers will have inconsistent profits and cash flow that could (and often do) disrupt the dividend.

The first and easiest place to check when evaluating this criteria is the payout ratio. This ratio tells you the percentage of a company's profits that are distributed to shareholders. If a company's payout ratio is 75% or higher, it could indicate that it's profits are not sufficient to continue paying that dividend.

New York Community Bancorp (NYSE: NYCB) is a great example. This is one of the highest-performing banks in the nation, and it pays a very strong 5.9% dividend yield. However, the bank's payout ratio stands at over 90% of profit. That leaves virtually no wiggle room for the bank to maintain the dividend if there is a hiccup to profits or a need for more capital. In other words, if anything at all goes wrong, the bank will probably have to cut the dividend.

Start with stability and the rest will followAnalyzing capital and profit are a great way to check out a company's dividend from a financial perspective, but if you step back and view the forest from the trees, you'll see it all boils down to stability.

In your own analysis, in turn, I encourage you to prioritize stability and then confirm it with a look at the company's capital and profit in relation to the dividend paid.

The article What Separates a Good Dividend From a Great Dividend originally appeared on Fool.com.

Jay Jenkins has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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