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The power of dividends has helped millions of investors turn savings into true wealth. But thousands of stocks pay dividends. How do you know which dividend stock is right for you?
Not all dividend stocks are alike
The first thing you need to realize about dividend stocks is that companies pay dividends for a bunch of different reasons. That means that if you just look at the dividend yields of two different stocks and try to compare them, you might end up making big mistakes about which one is more promising.
Let's take a closer look at what motivates companies to pay dividends.
In the past, nearly all stocks paid dividends. Rather than being satisfied with paper gains, stock investors demanded some tangible reward for their capital. Moreover, the expectation shareholders had was that if their company was successful, the dividend they received would grow over time.
As a result, you'll find that most companies that have been around for decades pay dividends, and many of them have long track records of dividend growth. Procter & Gamble (NYSE: PG ) , for instance, currently sports a 2.9% dividend yield. That's not shabby, but it's not terribly impressive, either -- until you realize that the stock has increased its payout at a 12% pace over the past five years, and has increased its dividend each year for the past 56 years. Similarly, 3M (NYSE: MMM ) has also been increasing its dividends steadily since the 1950s.
Notice that both of these companies pay out less than half of their earnings as dividends. That tells you not only that the dividend is sustainable but also that there's room for the company to weather recessions or slowdowns without threatening the payout.
2. Legal requirements.
Some companies are required to pay dividends. For example, real estate investment trusts (REITs) enjoy a benefit most corporations don't: They don't have to pay corporate tax. In exchange, though, they're required to pay out at least 90% of their earnings to shareholders in the form of dividends.
That means when you see REITs paying extremely high dividends, you have to look more closely to see if their dividends are sustainable. Annaly Capital Management (NYSE: NLY ) and Chimera Investment (NYSE: CIM ) both have dividend yields in excess of 15%. But they're both REITs, and with short-term interest rates so low, conditions are optimal for the companies' business model, which depends on borrowing cheaply to buy mortgage-backed securities that are paying better rates. When the spread between borrowing costs and income starts to fall, earnings will decline -- and that big dividend will disappear.
3. Return of capital.
In some cases, dividends you receive include part of the money you initially invested. For example, U.S. royalty trusts let you invest in a particular oil or gas property. As production continues, you receive dividends, but as the field gets depleted, those dividends trickle down to nothing, typically leaving you with a played-out stock. The royalty trust isn't permitted to invest in a new location to restore payouts.
That isn't the case for all energy-related companies. In Canada, for instance, similar entities are allowed to acquire new oil and gas properties. As a result, you'll often find Canadian entities reinvesting capital into new ventures. Penn West Energy (NYSE: PWE ) , for instance, pays fully taxable dividends with no return of capital component, yet it has maintained a 9% yield.
4. Holding on for dear life.
Some companies pay dividends that represent high current profits on declining businesses. Telecom companies Windstream (NYSE: WIN ) and Frontier Communications (NYSE: FTR ) , for example, have forward-looking dividend yields of 9% and 10.3% respectively.
Neither one earns nearly as much as its current payout. Each, though, has huge free cash flow that allows it to finance its dividend payments, because earnings are affected by depreciation allowances on capital investments the companies have already made. The growth prospects for these companies may not be stellar, but the payouts may be sufficient reward by themselves.
What to buy
Which type of dividend stock you want to own depends on your individual circumstances. If you don't need huge amounts of income right now, then more modest payers with opportunities for future growth are your best bet. To maximize income, though, some higher yielding stocks will serve you well, as long as you understand the prospective pitfalls.
Don't let dividends confuse you. Once you understand why stocks pay dividends, you'll be able to separate the best from the rest and buy stocks that work for your needs.
Don't get bogged down trying to find ultra-sophisticated investments. Read how Jordan DiPietro found five stocks that can make ordinary folks rich.