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Be Smart About High-Dividend Stocks

Historically, the best stocks to own for the long haul have paid consistent, growing dividends to investors. An oft-cited study from Ibbotson and professor Jeremy Siegel showed that dividends accounted for 97% of historical returns from stocks.

So looking for companies with a solid history of paying dividends makes sense, especially for beginning investors who are looking to create their first investment portfolio. But as you'll read in this month's issue of Motley Fool Green Light, which comes hot off the presses at 4 p.m. today, finding high-yielding stocks is just the first step. You also need to figure out how secure that dividend will be if you buy the stock.

Healthy dividends
These days, you'll find plenty of high-dividend stocks. Beaten-down sectors, such as financial stocks and homebuilders, have seen their dividend yields climb to extremely attractive levels. Some other industries, including bulk shipping, pay large dividends regularly. And certain companies, like real-estate investment trusts, are required to pay dividends in order to maintain their favored tax status.

The problem is that not all high-yielding stocks are good investments. Sometimes, a stock's price falls because investors think the company will reduce or discontinue dividend payments. If those fears prove true, those who bought in hopes of collecting a fat dividend often suffer the double hit of losing their dividend as well as a continuing drop in the stock price. Shareholders of Fannie Mae (NYSE: FNM  ) found that out yesterday, as the company slashed its dividend by 30%.

One way to evaluate whether a dividend is likely to continue is to look at the stock's payout ratio. By comparing a company's dividend payments with its net income, you'll get a good idea of whether the company is stretching to maintain its dividend or whether it has plenty of money both to pay shareholders and to make further investments in its business.

What you'll see
Here are some examples of companies, their dividends, and their payout ratios:

Company

Dividend Yield

Payout Ratio

Washington Mutual (NYSE:WM)

11.5%

71%

Wells Fargo (NYSE:WFC)

3.8%

46%

KB Home

4.8%

N/M

Altria Group (NYSE:MO)

3.9%

60%

Pfizer (NYSE:PFE)

4.9%

54%

Simon Property Group (NYSE:SPG)

3.4%

142%

Diana Shipping (NYSE:DSX)

6.6%

115%

Source: Yahoo! Finance.

As you can see, while all of these dividend yields are at relatively high levels, the companies have widely different payout ratios. KB Home actually lost money over the past year, which means it's paying its dividend from earnings from previous years. Simon Property and Diana Shipping are also paying out more than their net earnings. In general, a payout ratio higher than 100% means that over the long term, it's unlikely that the company will be able to sustain current dividend levels without extraordinary growth.

The payout ratio is also a useful tool for comparing companies in the same industry. For instance, both Washington Mutual and Wells Fargo have suffered losses from the ongoing mortgage crisis. Yet while Washington Mutual's large dividend seems unsustainable, Wells Fargo's more modest payout isn't straining the company's finances as of yet.

If you're just getting started, high-dividend stocks can be a great way to introduce yourself to stock investing. Just make sure you do your homework before you buy, and you can help yourself avoid the nasty surprise of a dividend cut.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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