How to choose the best dividend stocks for your ISA

What’s the perfect dividend? Every investor will have their own ideas, but I think it’s fair to say that most of us will agree on some requirements.

Firstly, the dividend must be affordable. It must offer a reasonable yield — something significantly more than you can get from a savings account. Finally, it should grow fast enough to keep pace with inflation.

To help maximise future gains, I invest most of my cash inside a stocks and shares ISA. That way I can be fairly sure I won’t ever have to pay tax on the income I hope to draw in the future.

To help identify some stocks which meet my requirements, I’ve used a simple stock screen with the following criteria. These correspond to those I’ve listed above:

  • Market cap > £500m
  • Forecast yield > 3.5%
  • Dividend cover greater than 1.5x
  • 5-year average dividend growth rate > 2%
  • Forecast dividend growth rate > 2%

What kind of companies did my screen provide? Here are three of the top results, listed in order of descending dividend growth.

Generating serious cash

Mining giant Rio Tinto (LSE: RIO) is trading very strongly at the moment. Reduced costs and a recovery in coal and iron ore prices have given a serious boost to the group’s profits.

Earnings per share are expected to rise by 21% to $4.16 this year. The dividend, which is set as a percentage share of earnings, is expected to rise by 34% to $2.23 per share. That’s equivalent to a yield of 5.5% at current prices.

The risk here is that this elevated level of profitability won’t be sustainable. Rio’s earnings and dividend are expected to fall in 2018, as market conditions change. I no longer think that Rio is a bargain after last year’s gains, but I’d continue to rate the stock as an income buy.

Unstoppable growth?

Tobacco group Imperial Brands (LSE: IMB) has now increased its dividend by 10% for eight consecutive years. Chief executive Alison Cooper says that the board “remain committed to this level of increase over the medium term”.

Net debt remains high at about £12bn, but Imperial has reduced this figure by £2.1bn over the last two years. The firm’s cash flow statement suggests to me that barring any further acquisitions, it should be able to continue funding debt repayments and its generous dividend over the next few years.

Some investors may have ethical objections to this stock. But with a 2017 forecast P/E of 14 and a prospective yield of 4.5%, I reckon Imperial looks an attractive income buy.

This contrarian pick could surprise

Electricals retailer Dixons Carphone (LSE: DC) has fallen by 32% over the last year as concerns have grown about the outlook for high street retailers.

The firm’s recent results haven’t really warranted this sell-off, in my view. Like-for-like sales rose by 4% during the six months to 29 October and also rose by 4% during the firm’s third quarter, which includes Christmas.

Dixon Carphone’s headline earnings rose by 45% to 10.9p per share during the first half. The interim dividend was increased by 8%. Based on consensus forecasts for the full year, the group trades on a forecast P/E of 9.8 with a prospective yield of 3.6%. These shares may be worth a closer look.

Five more dividend stock tips

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Roland Head owns shares of Rio Tinto. The Motley Fool UK has recommended Imperial Brands and Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.