Evaluating Dividend Stocks

Dividend stocks can account for an important part of a stock's total return, but you'll need to evaluate the stock's earnings growth and dividend coverage.

Many stocks pay dividends, but not all stocks are considered “dividend stocks," “income stocks," or yield stocks. In general terms, dividend stocks are ones for which the dividends are a primary reason for ownership. The stock price often is stable or might increase slowly.

Investors tend to think of dividends in terms of the dividend yield. That’s the ratio of a stock’s annual dividend to the current stock price; because the yield is based on the stock’s current price, the yield varies from day to day. As a reference point, the average dividend yield of stocks in the S&P 500 often ranges between about 2% and 4%. You can find stocks yielding 4%-6% or more, but you'll want to make sure the company is financially sound and the dividend is safe. That's because when a company's financial conditions worsen, dividends are sometimes cut or eliminated.

Dividend Payout Ratios

Since dividends are paid out of company earnings, it’s a good idea to know how much of the earnings went toward dividends. This is called the payout ratio. The higher the payout ratio, the more a company is dedicating earnings toward dividends and less toward growth or one of the other options for employing earnings.

A high payout ratio also increases the risk the company will need to cut the dividend if it encounters a downturn in earnings. In general, for most industries look for a ratio of 60% or less; utilities are an exception. But this percentage is just a rough rule of thumb. Our online stock selection tools provide up to 10 years of dividend payout information as well as annual dividend yield figures for the past five years. You can learn more about BetterInvesting's way of analyzing stocks via our a free sample of our resources, tools, and education.

When companies are small, they tend to devote little if any of their earnings to dividends. They’re often investing the earnings back into the business to build new facilities, research new products, hire more salespeople, and so on. As companies expand, at some point they’ll find it increasingly difficult to find new growth opportunities, leading to higher dividend payouts. That’s why the most popular dividend stocks often are those of larger companies.

Companies reconsider their dividends every quarter. When a company’s board of directors approves a dividend increase, it signals confidence in the company’s future earnings growth. Some companies have managed to steadily increase their dividends over decades.

Some companies do offer a combination of solid growth and dividends. As detailed in the article How to Find Good Dividend Stocks, we'll discuss how to find strong, growing companies with dividends that can provide steady income. 

Dividend Coverage

The dividend coverage ratio is a common metric for assessing the safety of a dividend. It's the ratio of the company's net income (the earnings after expenses, including taxes, are paid) divided by the dividend. For example, if a company has $50 million in net income and pays out $25 million in dividends, the dividend coverage, or dividend cover, is 2.0. (Note that the net income isn't necessarily the cash flow, which measures the money going into and out of a company's day-to-day operations.

Dividend coverage above 1.0 means the company's earnings are enough to cover dividend payouts. Many analysts consider a good dividend coverage figure to be above 2.0. Check several years of dividend coverage to see whether the ratio is declining or consistently below 1.5, both signs the current dividend could be at risk in the future.

Some companies pay dividends on so-called preferred stock. These shares have priority regarding dividends compared with common shares. When calculating dividend coverage, dividend payouts for preferred stock are subtracted from net income before dividing by the total dividend payments for common shares.

In evaluating dividend-paying stocks, keep in mind that there are special kinds of stocks known as real estate investment trusts, or REITs. These operate a little differently from other common stocks. REITs are required to distribute at least 90% of their taxable income to shareholders. As a result, REITs might have dividend yields of 5%, 6%, or more.