This post was originally made on June 29, 2006 on a former blog of mine.

So you’ve decided you want to own some dividend paying stocks or create an income producing portfolio for retirement, now what? Well unless you’ve hired an expert stock picker then you’ll probably be wanting to find some good stocks on your own. The following list of characteristics are things I look for in a dividend paying stock that has the long term potential I desire.

Payout Ratio. The payout ratio is simply the dividend payment divided by earnings. This is important because you do not want to buy a company who does not have the earnings necessary to meet its dividend obligations. If you look up a company on Yahoo Finance and the payout ratio says 160% or something similar then that means they paid out 1.6 times more than they earned. This type of thing can only be accomplished by either 1) taking on debt 2) paying out cash reserves or 3) having a wildly fluctuating business where quarterly earnings are not very smooth. There are some gurus out there who will give you hard and fast rules and say to never invest in a company whose payout ratio is above 60% or something along those lines. I tend to look at the business model to determine my limits. If a company has a stable, mature, highly predictable income stream (like tobacco companies or oil companies) then I will consider raising my limit to 85% or so. The point here is to make sure your company can pay for the dividends it announces!

Dividend Consistency. I like to see a solid history of dividend payments that preferably 1) always rise 2) always are paid 3) exhibit some degree of predictability. Take Big MO (Altria) for instance. You can see on their dividend history page that all of those conditions have been met. Don’t get confused by the fractions of penny payments a long time ago. Those figures have been adjusted to reflect stock splits and so forth so that we are comparing apples to apples. If you pull up a page like this and see wildly fluctuating payments that go up and down or a few payments have been skipped then you have a less predictable income stream. I will make rare exceptions for some cyclical and international businesses but as a whole the Altria history paints an almost perfect picture of what I like to see.

Dividend Growth. The long run increase in dividends for most companies is not much higher than the growth in GDP. There are, however, companies with exceptional management and competitive advantages in their business models that allow them to increase dividends at much higher rates for extended periods of time. I don’t have the time to show you how to calculate these growth rates but if you are familiar with MS Excel or a financial calculator then you should be able to plug in a few of these numbers and see for yourself. I like to find companies whose long run dividend growth rate is at least 10% for 10 or more years. I will sometimes settle for about 8% but usually not much lower than that.

A Few Notes on International Dividend Paying Stocks. I have lots of friends I talk to about this stuff who get all fired up when they find an international stock with a 10% yield or something like that. There are a few caveats you need to be aware of if you buy foreign dividend paying stocks.

• Exchange Rates - foreign stocks pay dividends in their local foreign currency. This then gets exchanged into your currency. If the foreign currency has been devalued versus your own currency since you bought the stock then your “real” dividend payment will be less than what you think it is. There is exchange rate risk here unless you hedge that somehow.


• Foreign Taxes - many foreign countries require companies to withhold foreign taxes from dividend payments. I recently received a dividend payment from a foreign telecom stock and 15% was withheld. This is not like the US where we don’t have to pay taxes until the following year. Be advised that these taxes will be withheld any time a dividend is paid. You may be able to deduct them from your own taxes but this takes a while!


• Payment Schedule - In the US we are sort of jaded by our expectation of quarterly dividends. There are many foreign companies who do not have that same requirement. If you check you will see that many foreign companies pay only twice a year or even only once per year. Building an income stream around these payments can be tough so make sure you know how many payments per year will be made and when. The longer the duration between payments the more exchange rate risk you are taking and the more you need to pay attention to your entry date.

I realize this is a ton of information to absorb but it’s here for a reason. Far too many people hear the benefits of dividends without ever experiencing the drawbacks. Don’t just use your favorite stock screener to find the companies with the highest yields. Make sure they have a solid dividend history and make sure you understand the risks associated with their business and/or location.

“Foolish consistency is the hobgoblin of small minds.” -Ralph Waldo Emerson

Note: Altria may be a client or personal holding. This is NOT a recommendation to buy it!

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