How to find the best dividend stocks

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History shows that dividend investing can be an excellent strategy for building your wealth over the long term. Here's how you might go about finding the best picks for your portfolio.

Size isn't everything

Rule number one: don't just throw your cash at those companies offering the biggest payouts. What looks a great investment today can quickly lose its shine if a business struggles to generate sufficient cash flow to pay its shareholders. Remember that the goal is to generate a decent but also sustainable level of income (even if you plan on reinvesting everything you receive).

In addition to this, it's worth finding out how often a company has hiked its total payout over the last decade or so. A consistently rising dividend points to a healthy business and confident management.

Looking at a company's payout ratio -- the proportion of earnings that get paid out as dividends -- is also important. A business returning only a modest percentage of its earnings back to shareholders has far more room to grow its dividend than one promising close to 100%.

Future earnings prospects should also be scrutinised. If it looks like profits will continue rising then it's safe to assume that dividends will follow. I'd also recommend checking how often earnings have increased over the last 10 years as a guide to just how resilient a company has shown itself to be.

To show how this might look in practice, I've screened for companies that are:

  • sufficiently large (market cap over £1bn)
  • offering a yield of at least 3%
  • generating positive free cashflow
  • forecast to continue growing earnings
  • returning less than 70% of earnings to shareholders

As well as the above, I've also searched for companies that have increased both the total dividend and earnings per share in at least seven of the last 10 years.

Here's what I found...

It perhaps isn't all that surprising that British American Tobacco(LSE: BATS) makes the grade. With excellent free cashflow and earnings per share increases in eight of the last 10 years, the company has only refrained from hiking its annual dividend once in the last decade.

Right now, the £99bn cap tobacco giant's shares come with a 3.5% yield. With a payout ratio of only 68% and earnings forecast to increase by 20% in 2017, this is surely one stock that won't let you down.

Boasting a forecast yield of 4%, advertising behemoth WPP(LSE: WPP) looks to be another great pick. Like its FTSE 100 peer, the Martin Sorrell-led company is predicted to increase earnings by 20% this year, leaving it trading at an attractive valuation of just 12 times earnings.

In addition to this, the £20bn business has a payout ratio of just 44%, suggesting there's ample room for dividends to continue rising in the future (payments have grown in eight of the last 10 years).

The third option in our trio of top dividend picks would be £6bn cap Hargreaves Lansdown(LSE: HL). While certainly not the cheapest to buy at almost 30 times earnings, the company has grown both profits and dividends in eight of the 10 years it's been on the market. There's a 3% yield pencilled in for this year and, with buckets of cash at its disposal and a payout ratio of 63%, I wouldn't bet against Hargreaves becoming even more popular with dividend hunters in the years ahead. 

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Paul Summers has no position in any shares mentioned. The Motley Fool UK has recommended Hargreaves Lansdown. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.