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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.

1. History.
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.

Fool contributor Dan Caplinger looks for dividends in everything he does. He owns shares of Chimera Investment. 3M is a Motley Fool Inside Value pick. The Fool owns shares of Procter & Gamble, which is a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is the best disclosure policy you'll find anywhere.

Read/Post Comments (9) | Recommend This Article (66)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 21, 2010, at 11:11 AM, DR1P wrote:


    If you are going to write an article about dividends why is it that you make no mention of one thing that a lot of people should find out... whether or not the dividend is a qualified dividend. You did open that door when you mentioned return of capital. PWE doesn't pay return of capital but it is a qualified dividend. It seems that most people writing articles can't see the need in mentioning those facts about the dividends they mention. Facts that can have a big effect on how good the dividend is for your portfolio due to the way it is taxed.

    You also didn't mention Timber REITs which pay a dividend that is classified, at least for the most part, as a long term capital gain. A dividend that could definately be worth looking into for some people.

  • Report this Comment On July 21, 2010, at 11:42 AM, TMFGalagan wrote:

    @DR1P -

    Good point, although many dividend investors try to keep their dividend stocks in tax-favored accounts like IRAs in order to avoid the whole tax issue entirely. Also, it's hard to discuss the tax issue fully in a short article.

    For more on dividends and taxes, though, here's an article from Foolish tax expert Roy Lewis. It's from 2003, but the general rules still mostly apply.


    dan (TMF Galagan)

  • Report this Comment On July 21, 2010, at 2:37 PM, Puckplayr4 wrote:

    Thank you! I read recently that Canadian Royal Trusts are experiencing a change in their tax laws in 2011 and are going to lose a lot of the tax benefits. I can't seem to find anything on what's going to happen Jan 1, 2011, does PWE and ERF just stop paying a dividend? Lower it to 2%? Tax me more for the foreign deal...I'd love to know what that issue means to me because I LOVE these two companies.

    Also, PWE and ERF pay monthly, which improves your compounding interest FYI.

    I am a beginning investor, but I am heavily weighted toward dividend payers. So much so that I ignore most stock that don't pay simply because that's a guessing game I'm just not ready for. But Utility, Energy, and Telecomm companies that pay a high dividend...notw that's a business model I understand. These aren't optional expenditures like Sirius/XM...they are sustainable costs of doing business and/or surviving. That's moat I understand.

    I'm sure I have a few eye-brow raisers in here, but this is my new ShareBuilder regular investment plan

    ADP (Thanks to your shout-out!)


    ALSK (I'm not liking their -P/E though)



    BPT (I'll worry about this one is 2020)

    CPL (Thanks TMF Matt Kopf! - Go World Cup 2014)


    EDE (one of my fav's)


    NGG (my newest fave)

    NLY (switched everything from MAC and NRF to NLY and OHI)

    NRF (I guess not everything. How did this one slip back in?)

    OHI (THanks DR1P [Dan], I am going to look up Timber REITs, I'd like to be more diversified)


    PRGN (Greek shipper still paying a dividend...hope this ship continues to float!)


    TYY (Another new Fave)


    VOD (Did you know they have an interest in VZ?)

    WWE (LOVE THIS ONE...Wrestlemania freaks paying me! AMEN BROTHER!)

    I know some of these are a little unsavory/risky...I got into NRF at a 0.25 dividend and can't seem to let go...but since I can't tell if its the bulls or the bears that have it right about APPLE, GOOG, Netflix, or Chipotle, I'm happy to build toward a strong retirement income with companies paying me to come along for the ride.

  • Report this Comment On July 21, 2010, at 3:49 PM, TMFGalagan wrote:

    @Puckplayr4 - Essentially, the CanRoys will have to start paying corporate-level tax, which they haven't had to do previously. What's likely to happen is that some of what investors used to get as dividends will instead go toward corporate tax.

    Read more about them from my fellow Fool Matt Koppenheffer:


    dan (TMF Galagan)

  • Report this Comment On July 22, 2010, at 5:22 PM, DR1P wrote:


    So, when Canada starts taxing the CanRoys as corporations, I don't suppose that will change the fact that Canada takes 15% off the top of the dividends, will it?

  • Report this Comment On July 23, 2010, at 3:49 PM, billqpgmr wrote:

    No, I don't think the canroys will stop taking that 15%...which is why you DON'T want to have foreign dividend payers in your IRA's. In a taxable account, you can declare that foreign tax paid as a credit on your income taxes - where you don't get that option in your IRA.

    PUCK, I see many of your entries are Dividend Investor picks, with some outside diversification.

    I agree with you on BPT, I might think about dumping in a few years, but I sure like it now.

    And I see you went for PM International, rather than MO...I have both.

    I have PVX, which is going through some changes, I need to check out PWE...

    NLY and such do make sense in IRA's, since they are non-qualified dividends...and while talking about tax implications, remainder royaltys and MLP's give additional tax breaks as well as decent dividents, and those can be in the IRA and still take advantage of the tax breaks. Adds a little to the tax prep time and delays filing a bit, usually, but I think worth it.

  • Report this Comment On July 23, 2010, at 8:16 PM, philkek wrote:

    Thanks MF and fellow fools. Good article with lots of companies to do further research on. Better Business Bureau says "investigate before you invest."

    Fool on for profits.

  • Report this Comment On July 24, 2010, at 4:38 PM, tomd728 wrote:

    puckplayr & Dan

    I'm an avid fan of NLY and I certainly appreciate

    your mention of the monthly dividends payers (or distributions) and the long term power of that


    A lot of talk always on Core holdings.More than a few of the stocks mentioned certainly qualify for

    the Core category.

    Thank you all and a fine piece !


  • Report this Comment On July 26, 2010, at 12:01 PM, plange01 wrote:

    nly,cim,mo,pm,vz,t,kft these are all great dividend current prices my favorites are cim,vz and nly. i own all except for t....

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