Finding good dividend stocks goes way beyond simply selecting stocks that have high current yields.

First, it is supremely important to identify whether or not a company is well-managed and fundamentally strong, thus ensuring that the dividend is reasonably secure and well-supported by the company’s profits.

After all, a company that isn’t earning profits won’t be able to make dividend payments for very long!

If you want the possibility that a company’s dividends will grow in the future, you need to ensure that it has a track record of growing sales and earnings in the past, and that it has identifiable opportunities to continue growing those in the future.

As is discussed in How to Start Investing in Dividend Stocks, companies that pay dividends are distributing their profits to shareholders in those (typically) quarterly payments. That also means that the monies paid out in dividends are no longer available for building new factories, hiring new staff, or otherwise expanding the company’s business.

Very mature companies may be content with earning enough to pay consistent, increasing dividends, and not be particularly worry about growing their business. Other companies balance the responsibility of paying dividends along with growing their core businesses.

As a result, companies that pay high dividends but do not have the fundamentals to back up those payments can be terrible investments. Companies with flatlined or declining earnings per share (EPS) and revenue growth, shrinking profit margins, and rising debt are often the weakest candidates for a long-term oriented portfolio—despite their high yields.

In fact, those high yields may be a sign that the dividend may well come under threat, and the company forced to slash or eliminate their dividend. When that happens, the company’s stock price will usually fall drastically, which can be ruinous for your portfolio’s total return.

A Better Idea: Seek Earnings Growth and Dividend Growth

When investors select stocks for their dividends, many focus so heavily on receiving a high yield that they forget all about a company’s quality.

Instead of simply chasing high yielding stocks, a better approach can be to seek dividend-paying companies that have a strong growth profile and show signs of excellent management. These companies have: 

• Solid and consistent sales and earnings growth over time (though not at the same high growth rates that investors usually seek for a growth-focused stock portfolios);
• Stable or growing pretax profit margins;
• Stable or expanding returns on equity; and
• Reasonable price-earnings ratios as compared to their histories.

Not only will these kinds of high-quality companies offer better prospects for long-term success in the stock market, their strong earnings strength will:

• More securely cover their dividends with profits;
• Allow for the opportunity for dividends to be increased over time; and
• Retain some earnings to reinvest in the company’s business, buy back shares, or make acquisitions.

Often, the stocks of these companies carry lower volatility as an added bonus.

Sources for Dividend Stock Ideas

The Standard & Poor’s Dividend Aristocrats is a list of primarily large-cap companies that have increased their annual dividends for at least 25 consecutive years. 

Typically, of the 65 or so companies that are Dividend Aristocrats, 60% of them report average EPS growth that exceeds 5.0% a year over their past decades.

Without their dividends, these blue chip stocks would not be of much interest to investors seeking capital appreciation due to their slower growth rates, but with their dividends may be good picks for a total return strategy that combines dividends with price growth, and with perhaps less risk than a portfolio made up mainly of growth stocks.
  Over the long-term, in fact, the Dividend Aristocrats do tend to deliver a lower total return than the broader market, which many investors see as a worthwhile trade-off for the reduced volatility of these high-quality dividend payers. (You can read more about the downside of the Dividend Aristocrats here.)

For up-and-coming Dividend Aristocrat contenders, the Roster of Dividend Achievers maintained in StockCentral’s Dividend Center is another resource.

This regularly-updated list identifies companies with a decade-long history of not only paying but increasing their dividends each year. More than 375 companies usually make the grade, making it a source of ideas for future Aristocrats.

Another resource for discovering stocks with a strong dividend component is the Dividend Informer newsletter. Published by Equity Research Service (a division of ICLUBcentral, Inc., which is a wholly-owned subsidiary of NAIC/BetterInvesting), Dividend Informer’s analysts regularly uncover stocks with attractive dividend payouts and strong fundamentals.

The newsletter’s aim is to provide actionable opportunities through investing in growing companies with a track record of offering regular, increasing capital return in addition to potential for share price growth. 

The newsletter focuses on reasonably valued companies with solid balance sheets and significant free cash flow generation, allowing for the payment of consistent, growing dividends. A heavy emphasis is placed on dividend yield, of course, but the newsletter also highlights companies returning significant capital to shareholders via share repurchases and debt reduction.

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. According to Standard & Poor’s, dividends have contributed around 32% of total return for the large-cap focused S&P 500 since 1926, while capital appreciation has contributed 68%.

But you can’t maximize your portfolio’s total return if you overpay for dividend paying stocks. Paying a high price, as measured by the P/E ratio, can greatly reduce your portfolio’s overall total returns. You might enjoy receiving the regular dividend payments, but paying too high a price for a stock might mean you lose money when you sell it or earn a lower total return relative to other investments. 

The education and tools developed by BetterInvesting can help you identify the right price to pay for stocks—no matter if you are investing for growth, dividends, or a mix of the two.

Maintaining a Focus on Quality and Growth Rates

The BetterInvesting commonsense, time-tested process for analyzing stocks involves the same analytical steps for all stocks whether or not they pay a dividend. But there are some factors that require additional investigation to ensure that the company’s use of capital is prudent and the dividend is secure.

The first step is to make sure the company has demonstrated historical long-term sales and earnings growth at rates suitable for its size. You also want growth to be consistent to ensure that 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 projected growth rates, you determine the stock’s potential return using your expectations of a stock’s future P/E range. For large dividend-paying companies, the stock’s dividend then becomes the all-important third driver of total return.

The online tools available to BetterInvesting members 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.