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Why Smart Investors Buy Dividend Stocks

John Maxfield
January 27, 2012

Let's get a few things straight.

Dividend stocks are not cool. They are not exciting. And they do not make for good conversation topics at parties. They're like the trombone player from high school who never had a date to prom.

In fact, come to think of it, the only thing dividend stocks are good for is making money. And potentially lots of it. So if you're not interested in making money, then proceed no further. There's nothing glamorous to see here. But if you clicked on this article because you're greedy and want to get rich from investing, like most of us here at The Motley Fool, then read on.

The unsung virtue of dividends
If you take only two things away from this article, make it these principles.

First, stocks that pay higher dividends have historically outperformed stocks that pay lower dividends. As Fool analyst Morgan Housel has noted, $1,000 invested in the S&P 500 in 1957 was worth $176,000 by 2006. The same $1,000 invested in the top 10 S&P companies with the highest dividend yields (more on this below) was worth $1.3 million.

Second, companies that pay more in dividends typically tend to experience higher earnings growth in the future. A study by researchers Rob Arnott and Cliff Asness divided stocks into 10 groups by dividend yield and found that the highest-yielding 10% had the highest earnings growth over the next decade. In this interview, Wharton professor Jeremy Siegel implied this was because high dividends encourage company executives to focus on profitability as opposed to imprudent acquisitions and share buybacks.

But here's the really interesting thing: While corporate cash flows are at or near record levels, the companies making up the S&P 500 are paying out less in dividends than ever before. For most of the 20th century, companies paid out the majority of their earnings as dividends. But this began to change in the 1960s, as the dividend payout ratio -- the percentage of net income paid out as dividends -- slid from more than 60% to around 50%. As of the end of last year, it was down to 29%, leaving most shareholders as unwitting victims of the lower-payout trend.

Knowing and using the dividend yield
While the knowledge that dividend-paying stocks generally outperform their non-dividend-paying brethren is important, it's nevertheless only half the battle. You still have to know which dividend stocks are worthy of your capital. And this is where the dividend yield enters the equation -- literally and figuratively.

The dividend yield is a ratio that shows how much a company pays out in dividends relative to its share price. It's calculated by dividing the annual dividends paid per share by the price per share. Let's take pharmaceutical giant Johnson & Johnson's (NYSE: JNJ  ) stock as an example. Its share price is $65.22, and over the past year, it paid out $2.28 in dividends per share. Therefore, its dividend yield is 3.5% ($2.28 divided by $65.22).

Or how about consumer products giant Procter & Gamble (NYSE: PG  ) ? With the stock at $64.98 and $2.10 paid in dividends, its dividend yield is 3.2% ($2.10 divided by $64.98). I used these companies because both are textbook examples of core dividend stocks; their businesses are globally diversified and have earnings streams that are ample and consistent.

In addition to communicating expected return, moreover, the great thing about a dividend yield is that it also communicates risk. While dividend stocks in general are typically less risky than non-dividend-paying stocks, among dividend stocks, it's fair to start with the idea that one with an ultra-high dividend yield is riskier than one with a more reasonable yield.

A textbook example of this is provided by the mortgage real estate investment trusts Annaly Capital Management (NYSE: NLY