U.S. Markets open in 4 hrs 45 mins

Forget Dividend Yield: This is the Real Way to Pick a Dividend Stock

Wendy Connick, The Motley Fool

Nearly every investor can benefit from holding a few dividend stocks. Picking stocks for their dividends allows you to build up a lovely passive income stream: With a non-dividend stock you don't get any profit until you sell it, but a well-chosen dividend stock will keep on pumping out dividends quarter after quarter. Unfortunately, not all so-called dividend stocks live up to their promise.

Just because a company has paid out a dividend in the past doesn't mean it will continue to do so in the future. A company can choose at any time to change the amount of its dividend or quit paying it altogether.

Money pouring out of faucet

Image source: Getty Images.

Look beyond dividend yield

Dividend yield is the company's annual dividend divided by the price of its shares. The higher a stock's dividend yield, the more money it's paying to shareholders relative to the value of its stock. More money is a good thing, which is why investors shopping for dividend stocks sometimes focus solely on yield, even though it's only a small part of a much bigger picture.

For example, back in June, Frontier Communications Corporation (NASDAQ: FTR) was paying a jaw-dropping 12.6% dividend yield. Did that make it a good choice for dividend investors? Well, the company's business model is rapidly becoming obsolete, it's hemorrhaging customers, and its share price has plummeted 94% from its 2015 highs -- and those struggles led the company to eliminate its dividend in September. A high yield isn't worth much if a stock is headed for huge capital losses and dividend cuts.

When picking any stock, it's best to have the long haul in mind, and that goes double for dividend stocks. You want stocks that will not only produce reasonable growth for years to come, but also keep paying out growing dividends through it all.

How to pick a dividend stock

While past performance is no guarantee of future results, a stock that has paid out dividends quarter after quarter for years is likely to continue doing so, barring disaster. If a company's management has a proven commitment to rewarding shareholders through dividends, they will generally do their level best to keep up those payments.

Because dividends come out of a company's profits, an unprofitable company will not be able to sustain dividend payouts. And if it's using nearly all its profits to pay that dividend, then even a slight dip in earnings may force the dividend to be cut. Thus one of the best measures of a stock's ability to keep producing dividends is its payout ratio. The payout ratio is a stock's dividend divided by the company's earnings per share. The lower the payout ratio is, the more room the company has for dividend growth in the future.

For a strong indicator of future dividend growth in most industries (but see my caveat in the next paragraph), look for stocks whose payout ratio is at least 10% but under 50%. A super-low payout ratio implies that the company isn't interested in passing a lot of its profits to its shareholders, so such a stock probably isn't a good choice for dividend-seekers.

Note that there are exceptions to this guideline. For example, REITs are required to pay at least 90% of their taxable income as dividends, which means they will always have enormously high payout ratios. And certain industries tend to have higher or lower payout ratios than average. Utilities, for example, tend to have high payout ratios because of the predictable nature of their businesses; they don't need to fear a sudden drop in earnings that could force them to cut their dividend.

Consider Aflac Inc. (NYSE: AFL), an insurance company you'll probably remember as "the one with the big white duck on TV." Following the company's latest dividend hike, which will take effect next month, the stock will pay a fairly modest 2.15% dividend yield (as of September 2017, the average dividend yield across the S&P; 500 is about 1.95%). On the other hand, the stock's payout ratio is a remarkably low 28%. What's more, Aflac's 34 straight years of dividend increases place it comfortably among the dividend aristocrats -- i.e., companies that are in the S&P 500 index and have paid and raised their dividends for at least 25 consecutive years. These factors indicate that Aflac has potential to pay a growing dividend to years to come.

Other factors

When you're shopping for dividend stocks, it's important to consider all the same factors you would when choosing any stock. You want stocks with good valuations, room to grow, and excellent long-term prospects. If you can find a stock that hits all three of these targets and also shows strong dividend qualities, grab it. That's the kind of stock that will likely keep rewarding you for decades to come.

More From The Motley Fool

Wendy Connick has no position in any of the stocks mentioned. The Motley Fool recommends Aflac. The Motley Fool has a disclosure policy.