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Dividend Stock-Picking: Know the Ratios, Hedge the Risks

Stockpickr Staff

A great way to give your portfolio a boost is to look for stocks paying high dividends (see Value Stock-Picking: How to Find Top Dividend Plays"). Yes, with a good dividend-paying stock, you can get the potential double reward of dividend income and stock price growth.

In addition, a dividend sets a "floor" on the stock price. So if the stock price goes down, then the dividend yield goes up. This attracts investors looking for income. When that happens, with more buyers, the stock price goes up.

Why You Need to Look Beyond a High Dividend

It's not enough to just pick the highest dividend-payer from a stock screen . If you do only that, you risk investing in a company that might not really be able to pay that high dividend, which could lead to a double whammy: the dividend could be cut, or eliminated entirely, and the stock price can go south as well.

Before you buy a high dividend-paying stock, you need to look at the company's financials to determine whether there's enough cash to cover the dividend payment -- now and in the future. To help you gauge the health of a company's dividends, there are a few ratios you can check out.

First, look at the company's payout ratio, the percentage of earnings that the company pays as a dividend. A payout ratio of 70% or less generally means the dividend is safe. If the payout ratio is greater than 100%, that's a warning signal. For example, Citizens Communication(CZN Quote), which has a dividend yield of 9.3%, also has a 256% payout ratio. Why so high? Perhaps it's using debt or selling assets to pay the dividend. You need to research the company and find out.

Next, check out the debt-to-equity ratio and the current ratio, which are measures of the level of assets relative to liabilities .

If a company is carrying a lot of debt relative to its assets, that should set off an alarm bell. As with the payout ratio, a debt-to-equity ratio or current ratio over 100% could mean that the dividend might not be sustainable, and a rate of 70% or less is considered a safe level.

Reviewing these ratios will help you avoid being seduced by impossibly high yields. Take Frontline(FRO Quote), an oil tanker carrier with a yield of 16.6%. Is this astronomical dividend sustainable?

Its payout ratio of 109% and current ratio of 179% should give pause before clicking the buy button. On the other hand, perhaps the oil tanker business is so profitable that the company can continue to pay the rich dividend. Again, when you see ratios like this, you need to dig a little deeper to find what's going on.

Keep an Eye On the Flip Side

On the other end of the dividend spectrum, when a company cuts its dividend, it's often a sign of trouble, as with La-Z-Boy(LZB Quote), a furniture manufacturer hit hard by the housing slump, or Flagstar Bancorp(FBC Quote), a troubled mortgage lender, which eliminated its dividend entirely.

Your Dividend Stock-Picking Assignment

Your assignment is to find dividend stocks with healthy dividend-related ratios.

Step 1. On Stockpickr, create a portfolio called "High Dividend Stocks: [Your Stockpickr Username]." (To create a portfolio on Stockpickr, you'll need to first log-in. If you're currently not a Stockpickr member, you can register at www.stockpickr.com/register.)

Step 2. Select five dividend stocks from Stockpickr or TheStreet.com, by searching for the keywords "dividend" or "dividends."

To help you get started, check out: High Yield Warren Buffett Stocks and Top Dividend Stocks You've Never Heard Of on Stockpickr, and "The Top Dividend Stocks of the Week" on TheStreet.com.

For each stock, go to Yahoo! Finance and note the stock's payout ratio, current ratio, and debt/equity ratio. At the end of the trading day, record the closing price in the "Reason?" box on Stockpickr.

Here's how to find the dividend-related ratios on Yahoo! Finance:

1. On the specific stock quote page, click the "Key Statistics" link on the left hand side of the screen.

2. On the Key Statistics page, look for the "Dividends and Splits" section. That's where you'll find the payout ratio.

3. On the Key Statistics page, look for the "Balance Sheet" section. That's where you'll find the current ratio and total debt/equity ratio.

Step 3. Check back after two weeks, one month, six weeks, and three months to see how the company's price has held up and whether or not the company is still paying the dividend. If you're serious about picking solid dividend stocks, consider monitoring the health of each company's dividends for about three months.

Even in this challenging market environment, by doing fundamental analysis on high dividend paying stocks, you may be able to earn a better rate of return than a certificate of deposit (CD) or money market.