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How to uncover the best dividend stocks for your ISA

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The tax-free nature of an ISA wrapper makes it the perfect place for investors to store their dividend stocks. And with the tax-free dividend allowance falling to just £2,000 for the tax year beginning April 6, it has never been more attractive for investors to make use of the ISA tax benefits offered.

However, finding the best dividend stocks that you can rely on to produce returns year after year, is not easy. For example, stocks with a dividend yield of 6% might appear to be the best income plays at first glance, but a yield of this level usually indicates that investors do not believe it is sustainable. If they did, they would rush to buy the stock, pushing the yield down. 

So what traits should you be looking for in a top dividend stock?

To answer this question, I believe it’s best to look at what hasn’t worked, rather than what has. In other words, by looking at companies that have cut or eliminated their dividends, we can put together a list of traits to avoid.

Cash is king 

The most significant problem that seems to force most companies to cut dividends is a weak balance sheet or lack of cash flow. Businesses should only be paying a dividend if they have no other use for the cash. If they are borrowing to fund the payout or if debt is rising substantially, and management continues to increase the dividend, then this is a definite warning sign that the payout is not sustainable.

The lack of cash flow is another red flag. If free cash flow from operations does not cover the total annual dividend distribution, it could only be a matter of time before the payout has to be reduced.

Another trait to look out for is the dividend record. A firm that has cut its dividend in the past is likely to reduce it again in the future. Cyclical companies are a great example.

A few years ago, when commodity prices were falling, most of the miners in London took an axe to their dividends because they just could not sustain the payouts. Dividends have since recovered to record levels a result of both cost-cutting efforts and higher commodity prices. However, considering these companies’ record of dividend volatility, I would not bet on the dividends remaining where they are today forever.

Don’t ignore the underlying business 

A lack of business investment can be another indicator of an unsustainable dividend. 

Dividends can only grow if earnings do, so a business has to be investing in its underlying business. If management cuts investment to fund the dividend, it is bad news for income seekers. In fact, some research has shown that the best dividend stocks to own are those with a low payout ratio (paying out less to investors and investing more in the business) because these companies are investing in the future, which guarantees long-term dividend growth. 

So overall, by looking at what has not worked, I believe the best income stocks are those companies with strong balance sheets, robust cash flows, an uninterrupted dividend history and a low payout ratio.

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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.