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Dividend Edition: How to Pick Dividend-Paying Stocks

We’ve covered a lot of the important elements of dividend stock investing here in the last few months, from the importance of buying at low valuations to the benefits of increasing dividends. Yesterday, I rounded up a few of these essential lessons for the readers of Cabot Wealth Advisory, our...

We’ve covered a lot of the important elements of dividend stock investing here in the last few months, from the importance of buying at low valuations to the benefits of increasing dividends. Yesterday, I rounded up a few of these essential lessons for the readers of Cabot Wealth Advisory, our company’s other free email advisory (you can learn more about it here if you’re interested.) The primer was well received, so even though you may already be familiar with most of these tenets, I though it was worth running it here as a refresher. If you already look at dividend history, free cash flow and the payout when buying stocks for income: you get the day off!

Regardless of what other factors you consider as part of your investing system, there are a few good metrics for everyone to keep in mind when considering buying dividend-paying stocks for income.

The first is to simply look at the dividend itself: how long has the stock been paying a dividend? Has it ever been cut? How often has it been raised?

Companies that can pay or, even better, increase their dividends quarter after quarter and year after year are more likely to continue doing so in the future.

One easy way to find these stocks is to look at Standard & Poor’s list of “Dividend Aristocrats,” which are stocks that have increased their dividends every year for at least 25 years. The list currently comprises an impressive 51 companies, from 3M (MMM) to Walgreen Co. (WAG).

Bedspring inventor Leggett & Platt, Inc. (LEG) was the latest Dividend Aristocrat to be recommended in the Dividend Digest. In the September 10 Dividend Digest Daily Alert, Investors Intelligence Editors Michael Burke and John Gray wrote:

[LEG is] “only $3 away from its highest level since 2007. Breaking through there would open up the door for a move towards the all-time high of $30.68 from 2004. Overall, a clear primary uptrend, underpinned by trendline support, is underway since the March 2009 low.”

Since then, LEG has moved tantalizingly closer to its multi-year high at 26 and could actually break that level at any moment. Plus, being a dividend aristocrat, LEG has paid a dividend every quarter since the last quarter of 1987, and currently yields about 4.5%. Oh, and it doesn’t just make bedsprings anymore, the company is a diversified manufacturer of everything from steel wire to office chair bases.

Of course, history isn’t the only indication of a dividend’s safety. Another metric that income investors will find very useful in analyzing dividend-paying companies is free cash flow.

Free cash flow, simply, equals operating cash flow minus capital expenditures. In other words, it’s what’s left of income after the company spends what is has to. That number is important because, when all is going well, it’s where the money for dividends come from. (Companies that can’t afford to pay their dividends out of free cash flow are forced to either cut them or find the money elsewhere, which is usually only a temporary solution.)

Digests contributor Ingrid Hendershot, Editor of Hendershot Investments, wrote about the importance of free cash flow earlier this year, writing:

“Firms with strong free cash flows can invest in internal growth programs, fund acquisitions and provide consistent, value-creating returns to shareholders through growing cash dividends and share repurchases at attractive valuations. By following the cash a company generates, investors may determine if management is allocating the capital in shareholder-friendly ways.”

We’ve seen some companies with superb cash flow in the Dividend Digest recently. The latest Dividend Digest featured not one but two recommendations of NV Energy, Inc. (NVE), a utility that is using its cash flow to raise its dividend and buy back shares. One of the recommendations came from Dow Theory Forecasts Editor Richard J. Moroney, who wrote:

“The arrow is pointing up at NV Energy (NVE), where sales rose 10% in the June quarter after nine consecutive quarterly declines. The consensus projects profit growth of 58% this year and 2% next year, and estimates are on the rise in the wake of profit surprises in the March and June quarters. The company raised its dividend 31% in May and now yields 3.8%. NV says it generates sufficient cash flow to support both dividend hikes of about 10% a year going forward, with enough left over to retire some debt as well. NV Energy is being upgraded to A (above average) in our Utility Update and added to the Top 15 Utilities portfolio.”


The last important metric I’ll address here is a stock’s dividend payout ratio. The payout ratio tells you how much of its earnings a company is giving to its investors. You can easily find the payout ratio by dividing a stock’s annual dividend payment by its earnings per share (EPS):

Payout Ratio formula

For example, a company that reported EPS of $3.00 per share in 2011 and made four quarterly dividend payments of twenty cents each (for a total yearly dividend of $1) would have a payout ratio of 33%.

The primary red flag to watch out for when looking at payout ratios is a number that’s too high. With some exceptions for MLPs and other entities created specifically to pass along cash to investors, the payout ratio should generally show that the company has some cash left over to put back into the business, buy back shares and create a cushion for leaner times ahead.

A company handing over 90% of its earnings to shareholders, in other words, may have a hard time affording that same payment down the road. Younger, faster-growing companies generally hold on to more of their income for growth and stability than older, slower-growing companies that may feel the best use for the money is paying back shareholders.

Wishing you success in your investing and beyond,

Chloe Lutts

Editor of Dick Davis Dividend Digest

Chloe Lutts Jensen is the third generation of the Lutts family to join the family business. Prior to joining Cabot, Chloe worked as a financial reporter covering fixed income markets at Debtwire, a division of the Financial Times, and at Institutional Investor. At Cabot, she is a contributor to Cabot Wealth Daily.