Dividend Basket

Dividend payers deserve a berth in any long-term stock portfolio. But seemingly attractive dividend yields are not always as fetching as they may appear. Let's see which companies in the tobacco industry offer the most promising dividends.

Yields and growth rates and payout ratios, oh my!

Before we get to those companies, though, you should understand just why you'd want to own dividend payers. These stocks can contribute a huge chunk of growth to your portfolio in good times, and bolster it during market downturns.

As my colleague Matt Koppenheffer has noted: "Between 2000 and 2009, the average dividend-adjusted return on stocks with market caps above $5 billion and a trailing yield of 2.5% or better was a whopping 114%. Compare that to a 19% drop for the S&P 500."

When hunting for promising dividend payers, unsophisticated investors will often just look for the highest yields they can find. While these stocks will indeed pay out the most, the yield figures apply only for the current year. Extremely steep dividend yields can be precarious, and even solid ones are vulnerable to dividend cuts.

When evaluating a company's attractiveness in terms of its dividend, it's important to examine at least three factors:

1. The current yield
2. The dividend growth
3. The payout ratio

If a company has a middling dividend yield, but a history of increasing its payment substantially from year to year, it deserves extra consideration. A $3 dividend can become $7.80 in 10 years, if it grows at 10% annually. (It will top $20 after 20 years.) Thus, a 3% yield today may be more attractive than a 4% one, if the 3% company is rapidly increasing that dividend.

Next, consider the company's payout ratio, which reflects what percentage of income the company is spending on its dividend. In general, the lower the number, the better. A low payout ratio means there's plenty of room for generous dividend increases. It also means that much of the company's income remains in its hands, giving it a lot of flexibility. That money can fund the business's expansion, pay off debt, buy back shares, or even buy other companies. A steep payout ratio reflects little flexibility for the company, less room for dividend growth, and a stronger chance that if the company falls on hard times, it will have to reduce its dividend.

Peering into tobacco

Below, I've compiled some of the major dividend-paying players in the tobacco industry (and a few smaller outfits), ranked according to their dividend yields:

Company	Recent Yield	5-Year Avg. Annual Div. Growth Rate	Payout Ratio
Vector Group (NYSE: VGR)	9.3%	4.5%	241%
Altria (NYSE: MO)	6.3%	9.4%*	80%
Reynolds American (NYSE: RAI)	6.0%	12.6%	103%
Lorillard (NYSE: LO)	5.8%	6.9%*	63%
Philip Morris International (NYSE: PM)	4.5%	11.5%*	63%
British American Tobacco (AMEX: BTI)	2.8%	15.0%	76%

Data: Motley Fool CAPS. *Since 2008.

If you focus on dividend yield alone, you might end up with Vector Group, but it's not necessarily your best bet. Vector's payout ratio is huge, suggesting that its high yield may be illusory.
Instead, let's focus on the dividend growth rate first, where British American Tobacco and Reynolds American lead the way. Reynolds American also has a rather steep payout ratio, though, and British American Tobacco's yield is on the low side.

Just right

As I see it, while most of the companies above are worth a closer look, Altria and Philip Morris International give you the best of everything for a dividend stock. They sport yields above 4%, healthy dividend growth rates, and reasonable payout ratios. They offer some solid income now and a good chance of strong dividend growth in the future. Of course, as with all stocks, you'll want to look into more than just a company's dividend situation before making a purchase decision. Still, these stocks' compelling dividends make them great places to start your search, particularly if you're excited by the prospects for this industry.

Disclosure NONE.