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.
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 five tips to make your mission a little easier:
- 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.
- 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.
- 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.
- Evaluate risk vs. return. Remember that 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.
- 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.