First Person From a Stock Expert: Tips for Identifying Solid Dividend-Paying Stocks

With interest rates historically low, one place to look for income these days is dividend-paying stocks. Buying high-yielding stocks for the income they can generate can be a tempting and, in some cases, even a smart financial strategy. However, as a professional financial analyst and long-time stock market watcher, I know the value of doing your homework before making any investment. In evaluating dividend paying stocks, seek out companies that are well positioned to maintain and perhaps even increase their dividends. Here are six tips for identifying solid dividend-paying stocks.

Dividend Paying History: Look for companies that have a history of paying dividends through good times and bad, including the most recent recession, when many companies eliminated or reduced their dividend payments.

Dividend Increase History: Even better than just a history of paying dividends is a history of regular dividend increases.

Management Comments: Search company financial reports, presentation transcripts, interviews, etc. for management's or the Board of Directors' comments with regard to the company's dividend policy. In particular, look for comments that may reflect on the commitment to, safety of and trend in dividend payments.

Payout Ratio: The payout ratio is a company's annual dividend rate per share as a percent of its annual earnings per share. If the payout ratio is too high-for example, if it represents most of earnings-this could be a sign that the current dividend rate is unsustainable. On the other hand, if the payout ratio is modest, representing a relatively small percentage of earnings, this may be an indicator that the dividend is sustainable and perhaps will be increased. When evaluating the payout ratio, compare the current payout ratio to historical figures. If it is low relative to its average level in the past, this could auger well for a stable or rising dividend. Also, when analyzing the payout ratio, don't overlook the other part of the equation, the company's earnings. In particular, try to identify any one-time items that may have affected recent earnings, such as non-recurring gains or charges, since such items can skew the payout ratio temporarily and, therefore, make this figure misleading (unless earnings are adjusted for these items). Finally, compare a company's payout ratio to those of comparable companies in the same industry.

Cash Flow: A quick analysis of a company's cash flow statement can tell you a lot about its ability to continue to pay its dividend. The cash flow statement, along with the profit and loss statement and balance sheet, will appear in a company's 10-K filing with the Securities and Exchange Commission at www.sec.gov and in its annual report. When you look at this statement, you will see three main categories of cash generation or usage: cash generated or used by operations, cash generated or used by investments (which includes capital expenditures), and cash generated or used by financing activities (which is where dividend payments will appear). If a company's operations are generating more than enough cash to fund capital expenditures, the money left over (often called free cash flow) can be used for a variety of purposes, including paying dividends, repaying debt, repurchasing stock or adding to cash balances. The more free cash flow a company generates, especially relative to what it is expending on dividend payments, the better able it should be to maintain and perhaps increase its dividend.

Dividend Yield: A stock's dividend yield is the annual dividend per share divided by the share price per share. It is tempting to invest in companies with the highest dividend yield. However, be cautious if a company's dividend yield appears to be out of line with other companies in the same industry. It could indicate a weak stock price as a result of fundamental problems in the company's business, which, in turn, could put the dividend at risk.

Finally, I want to finish with a word of caution. Investing in stocks always carries some risk, and, as many investors learned in the last recession, when it comes to dividends, even seemingly safe dividends, there are no guarantees. Therefore, once you have done your homework and identified what you believe are solid, dividend-paying stocks, diversify your investment rather than putting all your money in one name.

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