Dividends can play an important role in any investor’s portfolio. They shouldn’t represent all of your investments, but investing in dividend-paying stocks can create a great source of income down the road. For older companies whose stock prices may not have room for hypergrowth, dividends offer a way to incentivize and reward investors. And when you look at the total returns of many investors, a big part of that comes from dividends.
When investing in dividend-paying stocks, be sure to dig a little deeper into the companies to make sure you’re making the right choice and not being fooled by what’s happening on the surface. When it comes to dividends, all that glitters isn’t gold.
Look beyond the dividend yield
Often the most advertised measure of dividend stocks is the dividend yield. A company’s dividend yield is its annual dividend payment relative to its stock price. If a company pays $2 in dividends per year and its stock price is $100, its dividend yield is 2%.
But that’s exactly why the dividend yield itself can be misleading. If that same company’s stock price fell to $50, its new yield would be 4%. Without digging deeper, this increase in yield may seem lucrative, but it doesn’t provide an explanation as to why the yield doubled, namely that the stock price halved.
In this case, the stock price could have fallen significantly due to factors unrelated to its underlying business, or it could have fallen because something substantial changed with the company and its operations. Either way, you always want to be aware of this, so you don’t invest blindly.
Don’t neglect the payout ratio
It’s one thing to have a solid dividend-paying stock, but you want to make sure the performance is sustainable over the long term. This is where a company’s payout ratio can come in handy. The payout ratio tells you how much of its profits a company pays out as dividends. You can calculate the dividend payout ratio by dividing a company’s annual dividend by its earnings per share (EPS), both of which can be found on your broker’s platform or the company’s financial statements.
A payout ratio above 100% means that the company pays out more dividends than it earns. Spoiler alert: that’s not a good thing. If a business continues to pay more than it brings in, it’s not sustainable in the long run. At some point, either the dividend will have to be cut or the company will run out of money. Neither is good for dividend-focused investors.
There is no set number you should look for when looking at a company’s payout ratio, as some industries are more dividend-friendly than others. But in general, you want to look for ratios between 30% and 50%, more or less.
Dividends can be a retirement supplement
One of the benefits of dividends is that they can provide additional income in retirement. If you are intentional with your dividend investing and take advantage of your broker’s dividend reinvestment program (DRIP) – which automatically reinvests dividends to buy more shares of the company or fund that paid them – you can easily find yourself in a situation where you receive thousands of dollars in monthly retirement income. All it takes is time and consistency.
Along the way, though, remember not to be fooled by misleading dividend yields; look deeper into Why. You will likely find (and hopefully avoid) some red flags along the way.