How to pick the best dividend stocks

If you are looking for a steady stream of income from your investments, you should be looking at dividend-paying stocks. Here we explain how to find companies that pay out a large portion of their earnings via regular and sustainable dividend payments.

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
How to pick the best dividend stocks

Global dividends at record levels

Investors looking to generate regular income from their investments will be pleased to hear that global dividends hit records levels in the second quarter of 2018. Strong economic data and high profitability growth helped global dividends rise by 12.9% compared with the same quarter last year.

Data compiled by Janus Henderson showed the value of dividends to be higher in all countries except the UK. However, those quick to hypothesise that the UK’s underperformance is due to the underwhelming progress Brexit negotiations have taken are mistaken. The real reason for the UK lagging behind the rest of the world was simply technical, with National Grid paying a large special dividend in the second quarter of 2017 and British American Tobacco switching from biannual to quarterly dividend payments.

The chart to the right-hand side below shows the growth in dividend payments by sector. Payout ratios for tech companies tend to be lower than other sectors, but since the fourth quarter of 2009 the sector has increased its dividends by nearly 350%. The report also shows that a quarter of all dividends were paid by financial firms.

What the data illustrates is the current strength of corporate balance sheets and bullish expectations for future earnings.

Source: Janus Henderson

How to find the best dividend stocks

How do you go about finding companies that pay large and sustainable dividends but also have the potential for future capital growth and are not ridiculously overvalued? Solely looking for companies with the highest dividend yield is ill-advised. To help separate the wheat from the chaff we have outlined some interesting financial metrics and ratios below.

1. Dividend yield

A company’s dividend yield is the amount that is paid out to shareholders compared with its share price. It essentially shows the amount of cash that you can expect to receive for each pound you have invested in the stock. The FTSE 100 index has an aggregate dividend yield of 4.2% while the FTSE All Share Index is a touch lower at 4%.

If you find a company with an especially high dividend yield it is prudent to compare it with other companies in the same industry. A dividend yield that is far higher than the industry average could be a result of a depressed share price, which may be a sign that the dividend may be cut to a more conservative level or even scrapped if the company is in distress.

2. Dividend growth rate

To further investigate, investors should look to see whether the company has continuously increased its dividend over time. A company that increases sales year-on-year and sees a steady rise in profitability may choose to pass on these extra profits in the form of a higher dividend.

Although it is impossible to predict the future, a company that has increased its dividend consistently over a five-year period is displaying strong evidence that it will continue to do so.

3. Dividend payout ratio

When selecting high dividend yielding stocks to generate income, it is important to make sure that the dividend paid by the stocks you invest in are sustainable. A great way to see this is by looking at the dividend payout ratio, which is the percentage of net income that a company pays out as its dividend.

A company may pay a dividend that exceeds its annual earnings, but this is unsustainable in the long run and payouts will have to be cut unless earnings rise to bring the ratio back below 100%. It is therefore more favourable to invest in companies that have a low payout ratio.

4. Forward price-earnings (P/E) ratio

Even if a company ticks all the boxes for the criteria outlined above, it can still be an unattractive investment is the stock is considerably overvalued. To judge if you are getting bang for your buck, the forward P/E ratio takes the stock’s price and divides this by the company’s expected earnings over the next 12 months. The higher the ratio the more expensive the stock is perceived to be.

A general rule of thumb is that a P/E ratio over 20 times is an indicator that the company may be overvalued. We have written why we prefer the forward P/E ratio to the trailing P/E ratio in this previous article, which suggests global stock markets aren’t as expensive as many perceive them to be.

Creating a dividend-focused portfolio

While the metrics above can be useful for generating a list of companies with strong dividend-paying potential, they are not exhaustive and you should always do your own research before making an investment decision. When constructing a portfolio from dividend stocks, it is also important to make sure your portfolio is diversified across different industries and regions. However this can be both complicated and time-consuming for investors.

One alternative is to invest in a dividend-focused exchange traded fund (ETF). Earlier this year we picked out 6 of the best dividend ETFs for website ETF Stream. UK investors can buy and sell stocks and ETFs for as little as £5 per trade through our Share Dealing platform.

Read more about the highest yielding dividend stocks in the UK

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