Best Dividend Stocks — How to Screen for the Best of the Best

You've decided that dividends are the way to go for you. There are a lot of companies offering insanely high, one-time dividends. How do you pick companies that won't vaporize into thin air tomorrow?

How do you pick strong, sustainable companies that will continue to be profitable and grow their dividend ... the best dividend stocks?

Steps to Screen for the Best Dividend Stocks

Here are some of the drivers of a secure and growing dividend :

1. Low Debt Levels: The Balance Sheet should show manageable debt levels. In other words, look for a Quick Ratio of over 1 and a Debt-to-Equity Ratio of under 1.
   

   Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities

2. Decent Payout Ratio: The payout ratio is the dividend as a proportion of net income. Generally speaking, the payout ratio should be less than 80%.

3. Free Cash Flow Growth: From the Cash Flow Statement, if you take away Capital Expenditures from the Operating Cash Flow, you get what is called Free Cash Flow.

   Free Cash Flow can be used by the company to enhance shareholder value. Therefore, a growing Free Cash Flow is a good sign of dividend security.

4. Economic Moat: Does the company have an Economic Moat? Companies with economic moats have a much larger probability of continuing to grow for several years in the future.

5. Strong ROIC and ROE: Return on Invested Capital (ROIC) and Return on Equity (ROE) show how well a company uses capital available to it. These ratios upward of 10% usually indicate good, solid performance.

The Dividend Drill

Morningstar uses what they call The Dividend Drill to evaluate if a company is a good dividend candidate. We consider this an excellent method to evaluate the best dividend stocks out there.

Let's look at the highlights of this method with an example. We will use Abbott Laboratories (ABT) for our example.

The Dividend Drill is broken down into three main parts:

1. Current Dividend
   The first component is the current dividend yield. ABT, in early 2010, was trading at around $54. It's recent history of paying a dividend of $0.40 per quarter (or $1.6 a year), gives us an annual dividend yield of around 3%.

   ABT's current EPS is around $3.7. If you take away the dividend of $1.6, we are left with $2.1 of retained earnings. This is going to fund future dividend growth.

2. Assess the Company's Core Growth Potential
   

A good way to assess the company's core growth is to look at how its operating income has been growing over the last few years. For ABT, its operating income has been growing at an impressive annual rate of 9.8% over the last 5 years.

Based on this, let's forecast a 7% growth in operating income for the next 5 years. Assuming ABT will grow its dividend at a similar rate, our return now becomes 3% +7% = 10%.

But how much would it cost to fund this growth? One way to estimate this cost is to use what's called R3 ("R-cubed" for "required retention ratio").

R3 = Expected Growth Rate / Representative ROE.

For ABT, this works out to be 7%/23% = 30% of net income = .3 * 3.7 = $1.1 per share.

Let's take stock.... our return is up to 10% and we still have $1.4 ($3.7 EPS - $1.2 Dividend - $1.1 cost to fund core growth) per share to spare.

3. Evaluate the "Excess" Earnings
   ABT has an excess of $1.4 per share after it has paid dividends and funded core growth. It could use it to pay down debt, make an acquisition or buy back stock.

   To evaluate how much this last part is worth to our total return, we will assume ABT chooses to buy back stock with its $1.4 per share.

   This boosts up its current EPS by 2.6% ($1.4 / Current Share price of $54). When a company buys back shares the same earnings get distributed among fewer shares thereby propping up the EPS.

   This last part just gave ABT's EPS a 2.6% boost for next year!

Now it's time to add up our total return for ABT.

ABT total return = Div. Yield + Profit Growth + Excess Earnings Yield
ABT total return = 3% + 7% + 2.6% = 12.6%

It's important to note that this annual return is valid only at the stock price used for the calculation .... $54 here.

The Dividend Drill works well to identify the best dividend stocks. However, it can only be used for mature companies with a history of paying dividends. Companies that don't pay dividends or are new and growing don't lend themselves to this analysis.

To wrap up, we've discussed in great detail how to screen for the best dividend stocks. We illustrated a powerful method to calculate total return using an example. This knowledge should put you well on your way to intelligently evaluating dividend growth and assembling a powerful portfolio of the best dividend paying stocks.

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