It's hard to ignore the advantages of dividend investing. For income investors, dividend stocks can play a valuable role in their overall strategy by…
... combining the growth potential of stocks with an income stream normally found in bonds and interest-bearing instruments
... bringing an element of stability to a stock portfolio.
For real estate investors, diversifying into dividend stocks may also add some liquidity to their investments.
You can buy dividend stocks individually through a variety of online brokers or use them as part of a broader asset allocation strategy mapped out by a robo-advisor. Either way, it's important to understand how dividend stocks work and how to use them.
Top things to learn about dividend investing:
- What dividend stocks are
- How dividends are calculated
- How to use dividend yield and other measures to evaluate dividend stocks
What is a Dividend Stock?
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. A dividend is a cash payment to shareholders of a stock.
Though companies occasionally pay a special dividend, stocks that pay dividends usually do so once a quarter on a regularly scheduled date in amounts that are known in advance.
Anyone who owns the stock as of a certain date is entitled to the next dividend. That is known as the ex-dividend date.
How dividends are calculated
Dividends are paid on the basis of a certain amount per share. So, if you own 200 shares of a stock paying a dividend of 50 cents per share, you will receive a dividend payment of $100 (200 times 50 cents).
Companies can change their dividends or even discontinue them, though they have to announce these changes in advance. Generally speaking, companies try to keep their dividends as stable as possible.
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.
Not all stocks pay dividends, however. Newer companies whose earnings are somewhat uncertain often don't pay dividends. Also, fast-growing companies may prefer to reinvest all of their earnings in expansion rather than pay a dividend.
While stocks that pay dividends may all be considered dividend stocks, if you are interested in dividend investing, you may choose to focus on high-dividend stocks.
What Are High-Dividend Stocks?
When measuring the size of a dividend, instead of looking at the size of the per-share dividend, you should focus on the dividend yield. This is the annual total of the dividends divided by the price of the stock.
The dividend yield measures how much income you will earn as a percentage of your investment. In this sense, it is comparable to the interest yield on a bond or deposit account.
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.
As of mid-2020, the average large U.S. stock had a dividend yield of 1.84%. In a sense, then, anything with a dividend yield greater than 1.84% could be considered a relatively high dividend stock.
However, several of the highest dividend stocks had yields in excess of 2.5%. So this may be a level to shoot for if you are looking for truly high dividend stocks.
What Stocks Pay the Highest Dividends Now?
Based on price and dividend data from Yahoo! Finance as of 8/21/2020, MoneyRates.com calculated the ten best dividend-paying stocks in the Dow Jones Industrial Average:
|Company Name||Dividend yield|
|Exxon Mobil Corporation||8.49%|
|International Business Machines Corporation||5.29%|
|Walgreens Boots Alliance, Inc.||4.74%|
|Verizon Communications Inc.||4.17%|
|JPMorgan Chase & Co.||3.70%|
|The Coca-Cola Company||3.47%|
Note: These yields can change not just with changes in the dividends paid by these stocks, but also with fluctuations in stock prices.
How to Find the Best Long-Term Dividend Stocks
While knowing which stocks pay the highest dividends is a good starting point, there is more to dividend investing than that.
In addition to the dividend yield, it's helpful to know what indicates whether a stock's dividend yield will be sustainable.
Here are some characteristics that can help you choose the best dividend-paying stocks:
The dividend yield of a stock gives you a snapshot of information based on the current dividend and price. To put that in a long-term context, it helps to know the dividend history of a stock.
One thing to look at is how frequently the company has increased dividends over the years. If a company has consistently increased its dividend year in and year out, it's a sign of two positive things:
- Regular dividend increases generally suggest the company has been able to grow its earnings steadily.
- Regular dividend increases indicate that the company has a corporate finance strategy which includes providing a substantial cash return to investors.
While some companies may want to reinvest all the earnings they generate, others balance reinvesting in future growth with paying an immediate cash return to shareholders. The latter type of company is a better fit for dividend investors.
Besides dividend increases, it can help to look at how a company has managed its dividends during downturns. Some companies are more insistent than others on maintaining their dividends even during periods of earnings weakness.
Stocks that don't have a history of cutting their dividends as soon as earnings slip could be a good fit for dividend investors if that approach is continued in the future.
Dividend payout ratio: Dividends as a percentage of earnings
Over the long haul, a company pays its dividends out of the money it makes.
During periods of earnings weakness, a company can pay its dividends from reserves or other sources of cash. Ultimately, though, a company must generate earnings to be able to have cash to draw upon.
One way to tell whether a company is generating enough earnings to sustain its dividends is to look at dividends as a percentage of earnings. This is also known as the dividend payout ratio.
If a company pays out a high percentage of earnings as dividends, at first glance that might seem a generous policy. However, it can also be an indication that funding those dividends is becoming a bit of a stretch for the company.
When a company's dividend exceeds its earnings per share, it's a warning sign. That dividend won't be sustainable if the earnings don't turn around.
Even if a dividend represents more than half of a company's earnings, it should be a cause for concern. It suggests that the dividend might be at risk if there is any slippage in earnings. In any case, such a high dividend payout rate suggests that future dividend increases might be slow in coming.
The ideal situation for dividend investors is to find a stock with a high dividend yield but a relatively low dividend payout ratio. This indicates both a good near-term payout and a payout that is likely to be sustainable.
Dividend yields by sector
The nature of certain businesses makes them more likely to pay higher dividends. Companies with mature, fairly stable lines of business are generally best-positioned to pay out a higher portion of their earnings as dividends.
Having a lower dividend yield is not necessarily a sign of earnings weakness, though. Fast-growing companies often choose to pay little or no dividends so they can reinvest the cash they generate in expanding capacity.
Two industry sectors in which companies have historically been able to maintain relatively high dividend yields include utilities and real estate. However, the recent financial crisis has invoked major changes in the real estate sector.
In contrast, industry sectors that tend to have low dividend yields include information technology and consumer discretionary companies.
How to Evaluate the Company Paying Dividends
It's clear that, in order to pay a dividend, a company has to be in a good financial state. So what do you use to evaluate a company's financial condition?
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.
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.
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.
Checklist: How to Choose Dividend Stocks
Once you've learned 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 quick questions to ask:
1. Are the company's profits growing?
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. What is 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. Could the dividend be in danger?
Review recent news on the company to see if there are any red flags that could endanger future dividend payouts.
4. Did you evaluate risk vs. return?
Remember that higher dividend yields can mean more risk. A 7% dividend on a stock is not as attractive if the stock price declines by 10%. Balance risk and return, instead of simply picking the highest dividend yield.
5. What is the trend for this company and stock?
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.
Benefits of Dividend Investing
The following are some ways that dividend investing can help you:
Investment returns come from a combination of income-generation and price-appreciation. While dividend payouts can be changed, they don't vary nearly as frequently as stock prices.
This means that dividend stocks can add an element of relative stability to your investment portfolio. You can never tell what kind of price appreciation you're going to get from year to year, but you can reasonably estimate what income your dividend stocks will generate.
Alternative source of income
In today's low-interest-rate environment, income is hard to come by. This makes dividend stocks a more attractive alternative as a source of income-generation.
Large U.S. stocks currently have an average dividend yield of 1.84%. This compares favorably as a source of income-generation to the average interest rate of 0.274% on savings accounts or about 1.40% on long-term Treasury bonds.
While stocks are generally considered riskier than savings accounts or Treasury bonds, purely on the basis of income-generation they are currently very competitive. However, that depends on the income yield of the stocks you buy.
Because they provide both income and growth potential, dividend stocks can be a versatile component of your portfolio.
You can either use the income for immediate cash needs, reinvest the dividends in the company or use them to make other investments.
Some companies make reinvesting those dividends easy by offering dividend reinvestment plans (DRIPs). If you sign up for a DRIP, your dividends will be automatically reinvested in the company's stock. This allows you to steadily increase your investment in the company over time.
If you're interested in dividend investing, you can pursue this strategy by purchasing either individual stocks or income-oriented funds through a variety of online brokers. You may also find a robo-advisor that will construct a portfolio for you built around an objective of income-generation.