When selecting stocks for their dividend payouts, make sure they're high-quality stocks with a history of sales and earnings growth.

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When investors select stocks for their dividend payouts, many focus so much on receiving a high yield that they forget about a stock’s quality. For long-term success, you should focus on owning high-quality growth stocks with:

  • solid, consistent sales growth and earnings growth rates,
  • stable or growing pretax profitability,
  • stable or growing return on equity, and
  • reasonable price-earnings ratios.

We mention in How to Start Investing in Dividend Stocks that the money used to pay a dividend isn’t available for building new plants, hiring more salespeople, or making other investments to grow the business. But some companies balance both paying a dividend and maintaining good growth rates.

On the other hand, companies that pay high dividends but have weak fundamentals — negative sales and earnings growth, lack of operating profitability, and so on — can be poor investments. This companies might turn their performance around. But there’s also a chance they’ll eventually need to decrease or eliminate the dividend while the stock price and your total return suffer.

Combining Earnings Growth and Dividend Growth

By achieving consistent earnings growth rates, companies can fuel dividend growth. Some companies have managed to grow their dividend every year over the very long term. Standard & Poor’s maintains a Dividend Aristocrats list comprising S&P 500 companies that have increased dividends for at least 25 consecutive years.

As of October 2019 there were 57 companies on the Dividend Aristocrats list. Of those 57, 34 had five-year annual earnings growth rates exceeding 5%. For the large companies making up the S&P 500, 5% is a sufficient rate for an investor in growth stocks.

Paying the Right Price to Maximize Total Return

As mentioned in How to Start Investing in Dividend Stocks, dividends can be an important part of a stock’s total return — as of October 2019, dividends have provided about a third of the stock market’s total return since 1926, while stock price increases have contributed the other two-thirds, Standard & Poor’s says.

But in picking income stocks, make sure you’re paying the right price for them to maximize your potential return. Paying a high price, as measured by the P/E ratio, can damage your portfolio’s overall total return. You might enjoy the dividend payments, but overpaying for a stock means you can lose money when you sell it or earn a lower total return relative to other investments. Our education and tools can help you identify the right price to pay for stocks.

Maintaining a Focus on Quality and Growth Rates

BetterInvesting’s commonsense, time-tested process for analyzing stocks involves the same steps for all stocks whether or not they pay a dividend.

The first step is to make sure the company has demonstrated long-term sales growth and earnings growth at rates suitable for its size. You also want growth to be consistent to ensure the company’s management can sustain growth in good times and bad. Then you’ll check management’s ability to sustain profitability and use its resources well.

If the company passes both tests, you assess the company’s potential long-term sales and earnings growth. Finally, using those growth rates, you determine the stock’s potential return using your expectations of a stock’s future P/E range. The dividend yield can play an important part of the total return.

BetterInvesting’s online tools provide an orderly framework for studying a stock. To learn more about the process, read our series of articles on getting started with stocks, beginning with 6 Steps for Successful Stock Investing, or sample our resources and education for free.

Adam Ritt, Former Editor-in-Chief of BetterInvesting Magazine, joined BetterInvesting in 2002 as the managing editor of BetterInvesting Magazine and was overseeing the content creation and production of all BetterInvesting print and online publications.  His BetterInvesting Magazine articles frequently were reprinted in various publications. Adam’s article, “World of ADRs," is currently being used for a 400-level accounting course at the University of Washington

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