The Secret of Dividends

Between January 1926 and December 2006, 41% of the S&P 500's total return was due not to the price appreciation of the stocks in the index, but to the dividends its companies paid out. That's right -- a cool 41%. On an annualized basis, that amounts to 4.4 percentage points. To put it in dollars-and-cents terms, consider this: An investment of $10,000 over that stretch of time would have grown to $1,013,000 without dividends. With dividends kicked in and reinvested, however, that same sum would have been worth a whopping $24,113,000 by the end of the period.

Talk about the miracle of compound interest!

I learned most of the above from Motley Fool Income Investor, the investing service dedicated to picking the market's most promising dividend payers.

I've also learned that a dividend payout doesn't tell you a thing about a company on its own. A fat payout figure can even be a bad sign if it's the result of a stock price that's hit the skids, or if an examination of the company's cash flows indicates that its payout is unsustainable.

If you're interested in checking out more of the dos and don'ts of dividend investing, here's a must-read article on the topic. Among other things, the write-up zeroes in on a metric known as the payout ratio, and it recommends gauging that number relative to a prospective investment's asset class. While there's no magic number to look for (or avoid, for that matter), the article does provide a cheat sheet for dividend payers:

• Real estate investment trusts with a funds-from-operations payout ratio below 85%.
• Higher-growth common stocks that pay out less than 50% of free cash flow (FCF).
• Banks that pay out less than 60% of FCF.
• Regulated utilities that pay out less than 80% of FCF.

The commentary also encourages investors with inquiring minds to scrutinize the source of a company's cash, the caliber of its corporate management, and the historical reliability of the firm's payouts.

The power of dividends
What's that? You're a "story stock" type? Actually, I'd argue that even investors who generally favor racy fare like Comcast (Nasdaq: CMCSA), Genentech (NYSE: DNA), and eBay (Nasdaq: EBAY) -- none of which pays a dividend, by the way -- can reap the benefits of dividend-paying stocks. A portfolio of nothing but race cars is likely to lead to bumps in the road -- and perhaps even the occasional crash.

A fistful of comparative low-yielders such as Walgreen (NYSE: WAG) and Medtronic (NYSE: MDT) may not get the job done, either: Both currently yield less than the S&P. That's also true of Target (NYSE: TGT) and Schering-Plough (NYSE: SGP).

To truly soften a market downturn, a dividend must be substantial enough to offer meaningful cash returns, or, as Jeremy Siegel has shown, allow you to reinvest in additional shares of stock.

Want a little assistance in your quest for dividend dynamos? You're in luck. Income Investor has established quite the track record, having identified more than 60 top-notch dividend payers that have what it takes to beat the market over the long haul. The service's picks have outclassed the S&P's total return since the newsletter first opened for business, while beating up on the 500's yield as well.

With that in mind, I encourage you to take Income Investor for a risk-free spin by clicking right here. You'll have 30 days to explore the service and you're under no obligation to subscribe if you find it's not your cup of tea.

The plain facts show that dividend-paying stocks have outperformed in the past and that they have a good chance of doing so in the future. The secret, then, is this: Reinvest those dividends, and put the power of compounding to work in your portfolio.

This article was originally published on Jan. 18, 2006. It has been updated.

Shannon Zimmerman is the lead analyst for the Fool's Champion Funds newsletter service. He doesn't own any of the companies mentioned. eBay is a Motley Fool Stock Advisor recommendation. The Fool has a strict disclosure policy.