Now more than ever, investors look first for stocks that will pay them healthy dividend income. As a sign of stability and security, a decent dividend yield has become the first hurdle that many investors apply in their screening process for good investments.
As happens with any popular investing trend, some skeptics have worried that the popularity of dividend stocks has inflated their valuations above what's fair. Yet from a fundamental standpoint, the underpinnings of dividend stock prices appear to be strong, and they could keep getting even stronger for years to come.
Rising payouts support stock prices
The primary way to assess whether a dividend stock is fulfilling its purposes in your portfolio is to look at the income it generates. Just about the worst thing that a stock known for its dividend can do is to cut its payout, as it invalidates the investing thesis of many of its shareholders. That's the challenge that recent dividend cutters Chimera Investment (NYSE: CIM ) and Frontier Communications (Nasdaq: FTR ) face, as the double-whammy of big drops in share prices and significant drops in dividend income have pushed many investors to greener pastures after suffering big losses.
But, when you look at the overall market, dividend payouts broadly have never been better. As Barron's reported yesterday, S&P Dow Jones analyst Howard Silverblatt discovered that August's dividend payout of $34 billion from S&P 500 stocks will exceed the previous record level of $32.1 billion from last November. A big part of that comes from Apple (Nasdaq: AAPL ) , whose $2.65 per share quarterly dividend payout earlier this month amounts to about $2.5 billion in total payments to shareholders.
Even more importantly, Silverblatt notes that even without any changes at all, continuing dividend payouts at current levels would produce a rise of nearly 6% in aggregate dividend payouts in 2013. That should make dividend investors feel pretty confident about future prospects.
A market of stocks
As reassuring as it may sound to hear that dividends for the market as a whole look healthy, it doesn't excuse failing to look more closely at your portfolio to look for danger signs among the individual dividend stocks you own. Just because the overall market is well-off doesn't mean that you won't find problems with particular stocks.
Just a quick look at valuations across sectors can give you clues as to where warning signs may be flashing. Looking at data on forward earnings multiples from Factset Research, the telecom sector carries the priciest valuation, averaging 18 times next year's estimates. That's fully 40% higher than the multiple for the S&P 500 as a whole. Utilities, which are also well-known for high dividend payouts, are priced at 15 times forward earnings, well above their 10-year average multiple.
By contrast, areas where dividends have typically been less prevalent are relatively underpriced. Technology stocks are perhaps the biggest outlier, with a multiple below the market's average and nearly a third less than normal levels based on historical data. Yet even in the tech sector, you're seeing increasing dividend payouts, including a host of companies initiating new dividends. In fact, thanks in part to a big new dividend from Dell (Nasdaq: DELL ) and a huge increase from Cisco Systems (Nasdaq: CSCO ) , tech stocks now pay more in dividends than any other sector of the S&P.
The disparities across sectors suggest that one way to protect yourself would be to look more closely at the valuations of each stock you own and see whether they represent fair value. In some cases, you'll find that multiples aren't justified by growth expectations for earnings and dividend payouts. By concentrating instead on stocks that have a margin of safety in their valuations, you'll be better prepared for the most likely scenario: a selective bursting of the dividend bubble that focuses on overvalued individual securities.
Dividends are so popular as to resemble a fad, but that doesn't make all dividend stocks bad investments. It just means you have to be more careful to make sure you don't make avoidable mistakes. For the right stocks, the popularity of dividends could go on for years to come.
Even with its dividend cut, Frontier Communications remains a high-yielding play. But can the dividend last? Find out everything you need to know in the Fool's premium report on Frontier Communications today.