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Here's How to Find the Best Dividend Stocks

Keith Noonan, The Motley Fool

Dividend stocks offer investors regular passive income simply for owning shares in a given company. In addition, stocks that pay dividends have historically outperformed those that do not. Dividends are typically paid from a company's earnings or cash pile, and businesses that are generating strong cash flow and have strong financials are more likely to produce strong returns and attract investors.

As famous value investor Benjamin Graham outlined, in the short term, the stock market is a voting machine (or a popularity contest). However, in the long term, it's a weighing machine -- and things like earnings quality and dividend payments tend to make the difference over time.

With that in mind, it's helpful to have some weighing criteria to use, along with a clear outline of your investing goals, as you set out to find top dividend stocks.

A golden egg in a pile of paper money

Image source: Getty Images.

Weigh dividend metrics against business profile and outlook

A track record of consistent annual dividend growth can suggest that a company will continue to increase its payout, because investors become accustomed to regular increases and may move to dump such a stock if this track record isn't upheld. Having a decades-long history of consecutive annual payout increases doesn't guarantee that a company will keep its streak alive, and prioritizing dividend growth over other areas of the business can sometimes work to a company's detriment, but it's generally a good sign.

You'll also want to look at what percentage of a company's earnings and free cash flow (or, for some businesses, funds from operations) are being used to cover the dividend distribution. Safe payout ratios will vary depending on the business and the industry, but you can get a good idea of the overall profile by comparing a stock to others in similar positions, and looking at the company's specific needs in terms of capital allocation. You'll also want to look a stock's yield -- its total annualized payout divided by its current stock price.

Of course, having a big yield or low payout ratios won't mean much if the overall business isn't healthy enough to move forward and sustain its dividend distribution. Take a holistic approach to evaluating dividend stocks and businesses, and pay close attention to whether a business has a defensible moat and pathways to continued growth -- or at least solid enough performance and cash reserves to continue making payouts to shareholders.

Be clear about your goals

Great stocks are easy to identify in hindsight, but the types of investments that you should pursue will vary depending on what you hope to achieve and the amount of risk that makes sense to you.

High yield

If you're near or already in retirement, you'll likely want to focus on companies that offer big yield and have predictable businesses -- preserving wealth and having a reliable source of extra income are important in your nonworking years.

If you're looking for investments in this mold, good places to start are telecommunications companies, energy providers, and real estate investment trusts (REITs). For a look at a top candidate in the REIT space, the table below breaks down Realty Income's (NYSE: O) dividend profile:

Funds From Operations (FFO)

Yield

FFO Payout Ratio

Years of Uninterrupted Payout Growth

Payout Growth Over the Last Five Years

$944.27 million

4%

85%

25

23.9%

Data sources: Realty Income; Yahoo Finance, Dividend.com. FFO payout ratio based on results over the trailing-12-month period and forward annualized payout.

Realty Income generates revenue from renting out commercial real estate properties. While the overall brick-and-mortar retail space is facing pressure from e-commerce, Realty Income stands as one of the best-loved REITs on the market: Its list of commercial lessees is heavy on businesses like gyms, gas stations, dollar stores, and other operations that are likely to be resilient despite the rise of e-commerce and potential economic shakeups. Realty Income also pays out its dividend on a monthly basis, and is legally required (by virtue of its status as a REIT) to pay out at least 90% of its taxable income to shareholders in cash dividends -- characteristics that make it particularly attractive for retired investors.

Dividend growth

If you're a younger investor, you may want to focus on stocks that are rapidly boosting their payouts: These companies can build to having bigger yields over the long term, see faster earnings growth compared to companies that offer bigger yields, and help harness the power of compounding.

Starbucks (NASDAQ: SBUX) is a good example of a company in that mold; it's rapidly boosting its payout, and undertaking massive international expansion efforts that could power its next growth phases and help it continue to deliver big dividend increases. The coffee giant's dividend profile is summarized in the table below:

Free Cash Flow (FCF)

Yield

FCF Payout Ratio

Years of Uninterrupted Payout Growth

Payout Growth Over the Last Five Years

$3.34 billion

1.6%

54%

8

176.9%

Data sources: Starbucks; Yahoo Finance, Dividend.com. FCF payout ratios based on results over the trailing-12-month period (excluding the Nestle deal) and forward annualized payout.

Balancing the two

It can also be smart to strike a position somewhere in the middle by building a balanced portfolio that combines both high-yield and dividend-growth-focused stocks. Companies won't always fit into neat categories, and changes in performance or the needs of the business can be expected to alter capital allocation priorities.

Sometimes a company will deliver impressive earnings growth but opt to raise its dividend at a slower pace, choosing instead to invest resources in new growth initiatives or buy back stock. Microsoft (NASDAQ: MSFT) could be put into that category, and the table below breaks down some of its key business and dividend metrics:

Free Cash Flow (FCF)

Yield

FCF Payout Ratio

Years of Uninterrupted Payout Growth

Payout Growth Over the Last Five Years

$38.26 billion

1.3%

37.3%

15

64.3%

Data sources: Microsoft; Yahoo Finance, Dividend.com. FCF payout ratio based on results over the trailing-12-month period and forward annualized payout.

Under CEO Satya Nadella, Microsoft's transition to a recurring-revenue-focused, software-as-a-service, cloud-driven business has been hugely successful, and it's helped the company's diluted earnings per share double over the last five years. The business is still in growth mode, and spending to ensure that it stays at the forefront of important technology trends, but these investments also put it in a better position to maintain its dividend over the long term and continue delivering solid payout growth.

Investor takeaway

There's no clear-cut, unbreakable set of rules for the types of dividend stocks that will best serve a particular category of investors. However, there are general strategies and selection criteria that you can implement to put your money to work efficiently.

Whatever your goals are, it will help to define what you're hoping to achieve, then construct your portfolio with those ends in mind. This approach provides a lens to view things such as yield, growth rate, payout ratio, and overall business trajectory -- and then identify the types of dividend stocks that look best-positioned to help you meet your financial goals.

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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool's board of directors. Keith Noonan has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft and Starbucks. The Motley Fool has the following options: long January 2021 $85 calls on Microsoft. The Motley Fool has a disclosure policy.