Read This Before You Buy Dividend Stocks

These five questions will help you separate the winners from the losers.

Dividend stocks are often considered good defensive plays for frothy markets. But after an eight-year bull market, many dividend stocks now have historically low yields and historically high valuations — making them risky picks for conservative investors.

Yet investors who ask the right questions can still find some solid dividend plays in today’s market. Let’s take a look at the five main questions you should always ask when looking for sustainable income stocks.

1. Do you know the stock’s yield?

A stock’s yield equals its price divided by the dividend per share it paid out over the past year (its trailing yield) or the dividends which will be paid over the following year (its forward yield). The forward yield is generally more reliable, since it accounts for upcoming dividend reductions or hikes.

Income investors generally look for dividend stocks with yields higher than the S&P 500’s average yield of 2%. For example, AT&T (NYSE:T) and IBM (NYSE:IBM) are both popular dividend plays because they pay respective forward yields of 5.1% and 3.9%.

2. Do you know its payout ratio?

However, you shouldn’t simply chase the stocks with the highest yields. This can lead you straight to “high-yield traps” — or stocks that can’t maintain their dividend payments. You can usually spot these traps by checking their payout ratios.

Payout ratios equal the percentage of a company’s earnings per share or free cash flow (FCF) which was spent on dividends over the past year. If either of those percentages exceeds 100%, the dividend could be slashed in the near future. Here’s how AT&T and IBM’s payout ratios currently look:

SOURCE: YAHOO FINANCE.

Those ratios indicate that both companies’ dividends are sustainable. They also tell us that IBM, which has a lower yield than AT&T, can afford to pay higher dividends.

3. Are its earnings and FCF rising?

After checking a company’s yield and payout ratios, you should check if their earnings and FCF are still growing. For example, analysts expect AT&T and IBM to respectively post 2.5% and 0.8% earnings growth this year.

If we check these companies’ earnings reports, we’ll notice that AT&T expects its free cash flow to rise 6.5% to $18 billion for fiscal 2017, and that IBM expects its FCF to stay “relatively flat” this year. These growth figures indicate that AT&T has slightly better growth prospects than IBM.

4. Does the company raise its dividend every year?

The best income stocks raise their dividends every year to attract long-term income investors. Companies that pull that off for 25 straight years join an elite group of stocks known as the “dividend aristocrats”.

AT&T, one of the most well-known dividend aristocrats, has raised its dividend annually for over three decades. IBM comes close with 22 straight years of dividend hikes. When a company doesn’t raise its dividend every year, it tells us that its earnings growth is in trouble, or it prioritizes other things — like buybacks or acquisitions — over dividends.

5. Is it cheap relative to its industry and the overall market?

Low interest rates over the past few years caused many income investors to dump low-yielding bonds for high-yielding blue chip dividend stocks. As a result, many top dividend stocks now trade at high valuations — meaning that their P/E ratios are higher than the average ratios of their industries or the S&P 500.

For example, dividend stalwart Procter & Gamble (NYSE:PG) currently pays a forward yield of 3.1%, but it trades at 25 times earnings — which is higher than the industry average of 20 for personal products makers and the S&P 500’s current P/E of 24. Those numbers tell us that P&G isn’t a cheap income play at current prices.

When we view AT&T and IBM through the same lens, we’ll notice that they’re cheaper. AT&T trades at 19 times earnings, which is lower than the industry average of 22 for telecom companies. IBM has a P/E of 13, which is also lower than the industry average of 19 for IT services companies.

The key takeaways

Buying dividend stocks can be tricky, and requires more homework than simply choosing the stock with the highest yield. But if you filter your potential investments through these five questions, you should gain a clearer understanding of which qualities define a reliable dividend stock.

Leo Sun owns shares of AT&T.; The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.