If you're thinking of investing in dividend stocks, congratulations: That's a very sensible and likely profitable thing to do. A single stock's $0.35 quarterly dividend may seem puny, but many great fortunes have been built with the help of dividends. Still, as with any kind of investing, you should learn a lot about dividend stocks before you put in your hard-earned dollars.
Dividend stocks may not grow as briskly as other stocks
A key thing to understand about dividend stocks is that they will often grow more slowly than other stocks. Why? Well, remember that dividends are paid out with excess cash -- funds that management doesn't have better uses for. If a company were smaller and growing briskly, it would need every available dollar to be used to further its growth. It might spend that money on buying more advertising, hiring more workers, building new plants, or researching new products.
Dividend stocks may be more stable and reliable than others
Companies that are more established, such as blue chips, may still be growing and investing in their own growth, but not necessarily with all their earnings. Thus, they can afford to reward shareholders with some of the profits. Their revenue and earnings are probably more predictable than at younger, smaller, more dynamic companies, and this permits management to comfortably commit to paying dividends. This stability can be very welcome in economically turbulent times. If there's a downturn and stocks head south for a while, your healthy dividend stocks might see their share prices fall, but they'll still keep sending out those dividend payments.
Dividend stocks may boost your portfolio by more than you expect
If you're thinking you should probably add some dividend stocks to your portfolio, but you're not too enthusiastic because they will likely be boring slow growers, think again: Dividend stocks are actually great for a portfolio. Get this: According to Ned Davis Research, from 1972 through early 2016, dividend stocks averaged an annual gain of 8.8% versus just 2.2% for non-dividend payers. Indeed, from 1930 through 2014, dividends have accounted for about 40% of the 10.3% average annual return of the S&P 500. See? Not so boring anymore, right?
Note, too, that while non-dividend-paying stocks may sit in your portfolio, appreciating in value over time but not delivering any assets until you sell them, dividend payers will, obviously, be delivering cash to you regularly. Thus, even if you were to stop adding new money to your portfolio, new money would be accumulating in it, and you could use it to make additional investments. If you have a portfolio worth $300,000 with an average dividend yield of 3%, then you can expect to see about $9,000 appear in your account each year -- and that figure is likely to increase over time.
Dividend stocks need to be chosen carefully
So how can you zero in on the most promising dividend stocks? Well, first off, seek healthy, growing, promising companies -- because any payout on a stock will be tied to the success of the underlying company.
Here are a few more tips:
- Focus on the dividend yield, not the dividend amount; all things being equal, favor larger yields over smaller ones.
- Take note of how rapidly each dividend is being increased over time, because a company with a smaller yield could be the smarter buy if it's increasing its payout at a faster clip. In a few years, you might be reaping more from it than from a company with a (currently) fatter yield. Favor companies with strong dividend growth.
- Be wary of huge yields. Sometimes a really big dividend yield reflects a company going through a tough time, not a company that likes to reward shareholders with hefty payouts. After all, the dividend yield can be thought of as a fraction -- calculated by dividing the annual dividend amount by the current stock price. Thus, if the stock price drops, the yield will get bigger. Take a especially close look at any fat yields.
- Examine the payout ratio, which reflects the portion of a company's earnings that's being paid out in its dividends. If it's, say, 70% or less, there's room for continued dividend growth. If it's 100% or more, there's no room for growth -- or error -- and perhaps the dividend will even end up reduced.
So go ahead and seek dividend stocks for your portfolio, because they're likely to help it grow over time. Just do so with your eyes open, understanding their characteristics and potential. And remember that you can always invest in dividend stocks easily via a dividend-focused exchange-traded fund such as the iShares Select Dividend ETF (NYSEMKT:DVY).
Longtime Fool specialist Selena Maranjian, whom you can follow on Twitter, doesn't own shares of investments mentioned in this article. The Motley Fool doesn't own shares of any companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.