2 Keys to Picking Winning Dividend Stocks

After attempting to cook dinner, you notice something very odd with your oven. Every time you set it to 400 degrees, it only heats up to 100. The display reads 400, but your under-cooked food suggests otherwise. You do this time and time again, and the same thing happens. Here's my question: is your oven reliable? According to researchers, yes. The problem, instead, is that your oven isn't valid. When you look at dividend stocks like Wells Fargo (NYSE: WFC ) and Procter & Gamble (NYSE: PG ) , there's a small but important difference between "reliability" and "validity." To pick great dividend stocks you need to find businesses which show a mixture of the two.

Something's reliable if its results repeat over time. In terms of dividends, does the company have a history of consistently paying its dividend? Wells Fargo stumbled a bit during the financial crisis, but overall I'd consider it to have a reliable dividend. Validity is considered a measure of objective truth. It can also be seen as the ability of a tool to accurately measure what it's supposed to measure. While the oven was reliable, it was far from valid in its ability to measure temperature. Dividends work in much the same way. Here's how: since a company pays dividends from free cash flow -- or its cash generated after paying expenses -- think of dividends as a measure of how much free cash flow a company doesn't need to operate and grow its business.

Source: Motley Fool

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