About dividend stocks

As companies earn profits, that money can either be reinvested back in the business or paid to the shareholders of the company in the form of a dividend. Paying dividends is a sign of financial strength and a way to reward loyal shareholders. Companies that can pay dividends quarter-after-quarter, year-after-year earn the trust of investors and often find it easier to raise capital.

The dividend yield is the rate of dividend income an investor can expect at the current stock price and dividend payout. The dividend yield will change when the price of the stock goes up (yield decreases) or when the price goes down (yield increases). Historically, dividend yields will increase in good economic times and decrease during recessions and bear markets. Even though stocks are in a different investment class than bank deposits, investors will frequently compare dividend yields to the rates on certificates of deposit, money market accounts and savings accounts.

Judging a dividend stock

So how do you find a good dividend stock? In order to pay a dividend, a company has to be in a good financial state. You can start by screening the financial data of a stock at a site such as Morningstar or Yahoo! Finance. Here are a few of the financial numbers you should review:

• Return on Equity - This is a measure of profitability. Finding the return on equity (ROE) of different stocks can help you compare the relative strength of these companies.
• Market Capitalization - The size of a company -- or market cap as it is called -- is simply the number of shares multiplied by the current stock price. Typically, companies with a market cap of more than $1 billion are a more reliable bet to keep paying consistent dividends.
• Debt-to-Equity - If a company has too much debt, it may find it hard to pay dividends, especially if interest rates increase in the future. Look for companies with lower debt-to-equity ratios.
• Price-to-Earnings - The ratio that expresses the market valuation of a company is called the price-to-earnings (P/E) ratio. In essence, the ratio shows how much the market is to pay for $1 of its earnings. If a company has a low P/E ratio and an increasing dividend payout, the future could be bright for their stock.

Dividend News

This fall marked a period where dividend payouts have been decreasing. The primary reasons are two-fold. Firstly, the U.S. economy is still slumping and companies are hard-pressed for profits. Many companies have had to cut their dividends due to falling profits. Secondly, with interest rates generally moving lower, companies lower their dividend payout to remain in line with market interest rates.

Even with dividend yields moving lower in 2010, the number of companies that can afford to pay a dividend has increased. Of the 500 companies that make up the S&P 500 Index, 374 companies pay dividends at a current dividend yield of 2.40 percent. This yield may beat many of the best CD rates, but if you factor in the 126 companies that do not pay dividends, the dividend yield of the S&P 500 Index is only 1.9 percent. To give you some historical perspective, the average dividend yield of the S&P 500 Index from 1881 - 2010 is 4.35 percent. We still have a long way to go before investors are receiving dividends at historically normal levels.

A sign of a strong company is one that it can consistently pays dividends to shareholders. A special class of companies, called the Dividend Aristocrats, have made dividend payments for more than 25 consecutive years. If you are a safety-first investor, then the Dividend Aristocrats may be appealing to you. Some of the leaders include 3M (MMM) with 94 straight years of dividends, Coca-Cola with 117 years of consecutive dividends and tool-maker Stanley Black & Decker with 133 years in a row of paying shareholders a dividend. Now that's consistency.

Dogs of the Dow

A unique investing strategy, called Dogs of the Dow, involves buying the 10 DJIA stocks with the highest dividend yield at the beginning of the year. The portfolio is adjusted at the beginning of each year to include the 10 highest-yielding stocks. The Dogs of the Dow ended 2009 with a double-digit gain, which marked the best performance in the last three years.  Unfortunately, the "Dogs" under-performed the stock market when compared to broader measures such as the S&P 500 and the Dow Jones Industrial Average. In 2010, the Dogs of the Dow have done better. As of November 17, 2010, according to stock quotes from Morningstar, the Dogs have earned a 10.1 percent return year-to-date in comparison to a 7.3 percent return for the Dow Jones Industrial Average. Here are how the Dogs of the Dow stocks have performed individually this year:

 

AT&T Inc. (T)	0.75%
Verizon Communications Inc. (VZ)	3.92%
DuPont de Nemours (DD)	35.67%
Kraft Foods Inc. (KFT)	11.63%
Merck & Co. Inc. (MRK)	-6.68%
Pfizer Inc. (PFE)	-8.74%
Chevron Corp. (CVX)	7.13%
McDonald's Corp. (MCD)	23.99%
Home Depot Inc. (HD)	9.61%
Boeing Co. (BA)	15.98%

 

Stocks of interest

MoneyRates.com took a look at the dividend yields on some of America's most well-known companies. Dividend yields can fluctuate wildly as stock prices fluctuate, but they are still an important measure of the value of a stock. Listed below are a few dividend yields from prominent companies as found on Morningstar on November 17, 2010.

• AT&T (T) 5.95%
• Chevron (CVX) 1.60%
• Disney (DIS) 0.95%
• Bank of America (BAC) 0.34%
• Microsoft (MSFT) 2.48%
• Apple (AAPL) 0.16%
• Google (GOOG) - no dividend
• Pfizer (PFE) 4.34%
• Capital One Financial (COF) 0.52%
• Kraft Foods (KFT) 3.82%

You might note that technology companies such as Google and Apple pay very little or no dividends. This may seem odd, especially when you read that Apple has over $50 billion in cash on their balance sheet. To give you some perspective, Apple's cash balance is greater than the GDP of Costa Rica.

One reason tech companies will hoard cash in lieu of paying dividends is that they frequently use cash to buy other companies. For instance, if Apple ever tries to buy Facebook, they may need every penny of that $50 billion. Tech companies also aim to grow their market share and earnings rapidly. Paying dividends can get in the way of that goal.

5 tips for choosing dividend stocks

Once you've learned looked at the basics about dividend stocks, it's time to examine the next steps in finding the right dividend stock for your portfolio. Here are 5 tips to make your mission a little easier:

1. Determine if the company is growing its profits - It takes money to pay out money. A company that is growing its profits is more likely to keep paying out dividends or increase their dividend payout. Take a look at the profit estimates for a company before investing in their stock.

2. Find the dividend history of the company - Companies like to brag about their history of consecutive quarters of paying out dividends. If you find a company with a long history of dividends, you can trust that the company will not take breaking their streak lightly.

3. Check to see if the dividend could be in danger - Review recent news on the company to see if there are any red flags that could endanger future dividend payouts.

4. Evaluate risk vs. return - Remember higher dividend yields can mean more risk. A 7 percent dividend on a stock is not as attractive if the stock price declines by 10 percent. Balance risk and return, instead of simply picking the highest dividend yield.

5. Know that the trend is your friend - No one can predict the future, but trends do emerge that can help. Look at charts of the stock price, profits and dividend payouts to get a sense of the trending action of a dividend stock before you take the plunge and invest.

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